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••••••••••••••••  • ••••••••••  Lori L. Taylor  The Economic Impad of Bank Strudure: AReview of Recent Uterature Mark G. Guzman  The Effed of Welfare Reform and Technological Change on Unemployment Jason 1. Saving  This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)  Economic and financial Review Federal Reserve Bank of Dallas  Robert D. McTeer, Jr. President and Chief Executive Officer  Helen E. Holcomb First Vice President and Chief Operating Officer  Robert D. Hankins Senior Vice President, Banking Supervision  Harvey Rosenblum Senior Vice President and Director ofResearch  W. Michael Cox Senior Vice President and Chief Economist  Editors Stephen P. A. Brown Senior Economist and Assistant Vice President  Jeffery W. Gunther Research Officer  Mark A. Wynne Research Officer'  Director of Publications Kay Champagne Associate Editors Jennifer Afflerbach Monica Reeves Design and Production Gene Autry Laura J. Bell  Economic and Financial Review (ISSN 1526-3940), published quarterly by the Federal Resetve Bank of Dallas, presents in-depth information and analysis on monetary, financial, hanking, and other economic policy topics Articles are developed by economists in the Bank's Economic Research and Financial Industry Studies departments The views expressed are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System. Articles may he reprinted on the condition that the source is credited and the Public Affairs Department is provided with a copy of the publication containing the reprinted material Subscriptions are available free of charge, Please direct requests for subscriptions, back issues, and address changes to the Public Affairs Department, Federal Reserve Bank of Dallas, PO. Box 655906, Dallas, TX 75265·5906; call 214-922-5254; or subscribe via the Internet at www dallasfed.org Economic and Financial Review and other Bank publications are available on the Bank's web site, www dallasfed.org  Contents The [vidence on Government Competition Lori L. Taylor Page 2  The [conomic Impdct of Bdn~ hructure: ~ Review of Recent Literdture Mark G. Guzman Page 11  The Hfect of WelfMe Reform dnd Technolo~icdl Chdn~e on Unemployment Jason L. Saving Page 26  Society clearly benefits when businesses compete. The social benefits of government competition are still being debated, however. A large economics literature has sprung up to explore the premise that governments facing intense competitive pressure behave differently than do governments facing little or no competition. Lori Taylor examines the literature on government size, service quality, and productivity. She concludes that an ill-defined market for government, together with inconsistent and potentially inappropriate measuring sticks, raises the strong possibility that competition has been mismeasured in much of the literature on competition and government. Despite these flaws, the literature strongly supports one striking conclusion-competition improves public schools. Almost across the board, researchers have found that school spending is lower, academic outcomes are better, and school district efficiency is higher where parents have more choice of educational provider. Furthermore, competitive benefits appear regardless of whether the competitor is a private school or another public school.  The recent passage of the Financial Services Modernization Act, along with numerous bank mergers over the past few years, has focused attention on the banking system in general and on the sector's industrial organization in particular. Because of this, economists have recently begun developing theoretical models to more fully understand the economic impact of the industry's market structure. Mark Guzman reviews some of this research and draws two conclusions. First, a banking monopoly may benefit certain aspects of the economy. In particular, a monopoly bank can help overcome some of the informational problems inherent in the bank-borrower relationship. Second, how completely both the banking system and the economy are modeled is crucial to the results obtained. When ascertaining the overall economic impact, partial equilibrium models find either that monopoly is beneficial or that it is unclear whether it is beneficial or detrimental. In contrast, general equilibrium models find just the opposite: either monopoly is detrimental to the economy, or, at best, the impact is ambiguous.  Unemployment has fallen to its lowest level in a generation. Some welcome this development because they believe it increases the average person's ability to achieve the American dream. Others view low unemployment as a precursor to dire economic consequences. Jason Saving examines the issue of unemployment and reaches three main conclusions. First, welfare reform can significantly reduce unemployment, and the empirical evidence to date suggests the recent American welfare reform effort has caused hundreds of thousands of Americans to leave the welfare rolls and enter the labor force. Second, welfare reform can increase the official unemployment rate, but it cannot increase the number of people who are out of work. Finally, technological change can help low-skilled or disabled individuals become productive members of the labor force, and there is reason to believe it has done so during the 1990s.  Society clearly benefits when businesses compete. Competition forces firms to innovate and adopt least-cost methods of production. It rewards efficient producers and punishes inefficient ones. As such, competition is a key to economic prosperity in a market economy. The jury is still out on the social benefits of government competition, however. On one side of the debate are economists who argue that competition encourages governments to allocate resources efficiently and limits the fiefbuilding inefficiencies of governmental bureaucrats. (For seminal articles, see Tiebout 1956 and Brennan and Buchanan 1980.) On the other side are economists who argue that competition among governments amounts to little more than a zero-sum game in which governments squander resources chasing after mobile firms and “race to the bottom” in providing social services (for examples, see Burstein and Rolnick 1995 and the discussion in Oates 1999). Given the competing theories, the social impact of government competition becomes an empirical question. Not surprisingly, a large economics literature has sprung up to explore the premise that governments facing intense competitive pressure from other service providers behave differently than do governments facing little or no competition.1 This literature defines competitive pressure broadly to encompass not only horizontal competition among comparable governments or pieces of governments, but also vertical competition among different levels of government and external competition between public and private service providers. For example, when providing police services a typical city government can be viewed as competing horizontally with the police departments in other city governments; vertically with the county sheriff, state highway patrol, and Federal Bureau of Investigation; and externally with home security firms and private detective agencies. The three most important government behaviors that have been studied in the context of competition are government size, service quality, and productivity. Unfortunately, the existing literature does little to settle the debate. Only the literature on primary and secondary education provides clear and convincing evidence that competition influences government behavior.  The Evidence on Government Competition Lori L. Taylor  U  nfortunately, the existing  literature does little to settle the debate on the social benefits of government competition. Only the literature on primary and secondary education provides clear and convincing evidence that competition influences government behavior.  COMPETITION AND GOVERNMENT SIZE Lori L. Taylor is a senior economist and policy advisor in the Research Department at the Federal Reserve Bank of Dallas.  Brennan and Buchanan (1980) argue that bureaucrats have a self-aggrandizing interest in big government that can be at least partially  2  FEDERAL RESERVE BANK OF DALLAS  controlled by competition among governments. Their Leviathan theory predicts (among other things) that governments will be largest where competitive discipline is weakest. On the other hand, Anderson and Tollison (1988) argue that monopoly governments may restrict their output to earn economic rents, implying that competition could be associated with desirable increases in government size. In addition, Oates (1985, 1989) observes that fragmented governments could be too small to take advantage of economies of scale and, therefore, that the public sector could be larger where there are many small governments, despite presumably more competition among governments. A substantial empirical literature has sprung up to explore the relationship between competition and government size. In this literature, government size is typically measured as tax revenues or government spending, deflated by a measure of population, personal income, or gross area product.2 Researchers generally do not distinguish between governments that are larger because they provide many different services and governments that are larger because they provide large quantities of any given service. However, a number of researchers partially address this issue of governmental scope by differentiating between general-purpose governments (like counties and municipalities) and special-purpose governments (like school districts). While variations in the size of generalpurpose governments could reflect variations in the scope of government activity, variations in the size of special-purpose governments probably do not. The literature falls roughly into two camps—studies of the size of the public sector and studies of the size of individual governments. The public-sector literature examines the relationship between the degree of competition within a geographic area and the sum of government activity within that area. For example, it might relate the degree of competition among all governments within a county to the aggregate spending of all state, local, and national governments within that county. The unit of observation is a market for government services rather than any particular government. In contrast, the individual governments literature examines the relationship between the degree of competition in a geographic area and the size of individual government jurisdictions within that area. For example, this literature might relate the spending of county governments to the degree of competition in their respective metropolitan areas. The unit of ob-  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  servation is a specific government like a city or school district. Size of the Public Sector Public sector size has been examined nationally, regionally, and locally. As a general rule, the Leviathan hypothesis receives its strongest support from analyses at the local level. Oates (1985), Heil (1991), and Anderson and Van Den Berg (1998) use cross-country data on nations to examine the relationship between competition and the size of the public sector. They treat the central government’s share of total government activity as a measure of competitive pressure. Assuming that spending (or revenues) is the relevant measure of market share and that governments compete vertically as well as horizontally, their approach is analogous to measuring competition with a singlefirm concentration ratio. None of these researchers finds any evidence at the national level that competition affects the size of government. Studies at the state or provincial level suggest more of a relationship between competition and government size. Oates (1985) and Grossman (1989) find no correlation between the aggregate number of governments in a state and the size of its public sector, and Oates (1985), Di Matteo (1995), and Nelson (1986) find no relationship between the size of the nonfederal public sector and the state or province’s share of that market (another form of single-firm concentration ratio). However, when Nelson (1986, 1987) distinguishes between general-purpose and special-purpose governments, he finds evidence that state and local government is larger in states that have fewer general-purpose governments per capita. Furthermore, although Nelson finds no such relationship for special-purpose districts, Kenny and Schmidt (1994) and Bell (1988) find evidence that the public education sector is larger in states with relatively few school districts (per student in the Kenny and Schmidt study, per mile in the Bell study). Eberts and Gronberg (1988) and Zax (1989) replicate Nelson’s analysis at the local level. Zax focuses on counties, while Eberts and Gronberg examine metropolitan areas as well as counties. Both find evidence that competition among general-purpose governments reduces the size of the local public sector. Both also find that an increased number of special-purpose governments increases the size of the local public sector, an effect they attribute to a failure to exploit economies of scale. Eberts and Gron-  3  berg (1990) reach similar conclusions when they extend their analysis of metropolitan areas to differentiate between suburban governments, central cities, and other jurisdictions. Hoxby (1994a, b) also examines the size of the local public sector in metropolitan areas, but she restricts her attention to the education submarket. As in analyses at the state level by Kenny and Schmidt (1994) and Bell (1988), she finds that average per-pupil spending is substantially higher where the public education sector is highly concentrated (Hoxby 1994b). She also concludes that increased external competition from private schools reduces the size of the public school system, but only because it reduces the number of public school students (Hoxby 1994a). Hoxby finds no relationship between private school competition and average per-pupil spending.  opposite, however; competition is associated with increases in the size of general-purpose governments. Meanwhile, analyses of the most common form of special-purpose government— public schools —find that competition limits government spending. While these inconsistencies suggest that competition is not systematically related to government size, they also support Brown and Saving’s (1999) theoretical conclusion that government size may be a poor indicator of suboptimal government behavior. COMPETITION AND GOVERNMENT SERVICES While the previously discussed literature explores competition’s effects on government budgets, a complementary literature explores its effects on the services financed by those budgets. However, both the quantity and quality of government services can be hard to measure, particularly when governments are trying to accomplish multiple objectives. Therefore, the literature on government services is limited almost exclusively to studies of the one government function for which there is substantial data on outcomes— primary and secondary education. The literature strongly suggests that competition enhances public school quality. A number of researchers have examined the effects on student performance of competition among school districts. In all cases, the researchers measure competition with a Herfindahl index of enrollments.3 Zanzig (1997) finds evidence that increased competition among public school districts enhanced student test scores in California; Borland and Howsen (1992, 1993, 1996) report similar results for Kentucky.4 Hoxby’s (1994b) analysis of the National Longitudinal Survey of Youth suggests that students who attended high school in communities with more competition among public schools subsequently earned higher wages, scored higher on standardized tests, and completed more years of schooling. Dee (1998) and Hoxby (1994a) examine the effects of competition from private schools. Both measure private school competition as the private share of educational enrollment in the county and use instrumental variables techniques to reflect the possible endogeneity of private school enrollment. Both also use the county’s religious composition as the primary instrument for private school enrollment. Dee examines the effects of competition on average graduation rates, while Hoxby examines competition’s effects on educational attainment, graduation rates, test scores, and student wages. In  Size of Individual Governments As a general rule, competition does not appear to limit the size of individual jurisdictions. Forbes and Zampelli (1989) find that county governments are larger in metropolitan areas with more competing county governments. Similarly, Santerre (1991) finds that city governments are larger in metropolitan areas with more cities. Eberts and Gronberg (1990) find that central cities spend less on fire, police, parks, and sanitation in metropolitan areas with more municipalities (suburbs and central cities) but find no such distinction when size is measured by local tax revenues. Schneider (1989) finds a weakly negative relationship between municipal employment and competition, and no significant relationship between municipal wages and competition. Brokaw, Gale, and Merz (1995) conclude that school districts facing strong private-sector competition spend less per pupil than other school districts, but their evidence is not fully persuasive because in their study low public school spending may be a cause rather than a consequence of private school enrollment. Taken as a whole, the evidence on competition and government size is best described as inconsistent. There seems to be an important distinction between general-purpose governments and special-purpose governments. Analyses at both the state and local level suggest that competition among general-purpose governments reduces the size of the aggregate public sector, while competition among specialpurpose governments may increase it. Researchers who examine the size of the public sector’s component jurisdictions find just the  4  FEDERAL RESERVE BANK OF DALLAS  ciency frontiers for the educational system in each state and find that the school system is much less efficient in those states below a threshold number of school districts per capita. Grosskopf et al. (1999, 2000) estimate efficiency frontiers for urban Texas school districts and find evidence that school-district inefficiency is substantially higher in metropolitan areas with less competition for enrollment (both public and private). Barrow and Rouse (2000) use different empirics but the same theoretical model as Grossman, Mavros, and Wassmer (1999) to examine the effect of school-district spending on property values. They conclude that school districts spend less efficiently in areas with less competition from other public schools. In terms of external competition, Duncombe, Miner, and Ruggiero (1997) find that the cost efficiency of New York school districts is lower where private school enrollment is higher. However, because they do not treat private school enrollment as endogenous, their analysis may suffer from reverse causation whereby inefficient public schools induce flight to the private sector. After controlling for the possible endogeneity of private school enrollment, Dee (1998) and Couch, Shughart, and Williams (1993) find that increased competition from private schools improves public school outcomes, holding expenditures constant.5  all cases, the researchers find that student outcomes are better in areas with more competition from the private sector. COMPETITION AND GOVERNMENT PRODUCTIVITY The public sector’s productivity has received enormous attention in the economics literature, but only a few researchers have formally related the degree of public-sector efficiency to the intensity of the competitive environment. In general, this modest literature finds that local governments facing intense competitive pressure use their resources more efficiently than local governments facing less competition. Grossman, Mavros, and Wassmer (1999) examine the relationship between competition and efficiency for the central cities of 49 U.S. metropolitan statistical areas (MSAs). Arguing that an efficient city government will maximize property values, they use frontier estimation techniques and panel data to measure the extent to which aggregate city property values are less than maximal. Their estimation technique allows the deviations from the property-value frontier to be a function of several factors, including the degree of horizontal government competition. They measure competition as the number of cities in the MSA, the average population of those cities, and the number of U.S. cities in the central city’s census population group. They find that central cities move closer to the property-value frontier (that is, become more technically efficient) as the number and average population of competing suburban cities increase. Hayes, Razzolini, and Ross (1998) employ a two-step procedure to examine the behavior of Illinois municipalities. In the first step, they estimate efficiency measures for municipalities, using proxies for police and fire services as the outputs. In the second step, they regress the efficiency measures on a set of municipal characteristics, including whether the jurisdiction is a Chicago suburb and whether it is urban, which they interpret as indicators of the degree of competitive pressure facing local bureaucrats. They find that Chicago suburbs are less wasteful than other governments in Illinois, a factor they attribute to enhanced competition for residents. The remaining literature examines competition’s effects on the productivity of the U.S. public school system. The evidence suggests that increased competition—regardless of the source—enhances the productivity of public schools. Husted and Kenny (1996) estimate effi-  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  IMPLICATIONS AND CONCLUSIONS As the survey above illustrates, a substantial literature examines the premise that governments facing intense competitive pressure from other service providers behave differently than do governments facing little or no competition. However, the literature suffers from two significant weaknesses that make it difficult to draw firm conclusions from the collected research. First, the literature lacks a consistent definition of the market for government services. Some researchers use national, state, or county boundaries to define the market.6 In these studies, governments are assumed to compete with all other governments inside the designated boundary but not with those outside the lines. Such an approach is problematic for a number of reasons. For example, while it may be plausible that competition across national borders was negligible in the past, today’s world of mobile capital and labor makes such an assumption less defensible. The assumption that governments do not compete across state or county lines is implausible on its face. Furthermore, while it is reasonable to believe that all  5  population (for examples, see Oates 1985; Grossman 1989; Nelson 1986, 1987; Bell 1988; or Grossman, Mavros, and Wassmer 1999), but numerous studies use direct measures of market concentration like Herfindahl indexes or concentration ratios (Eberts and Gronberg 1990; Borland and Howsen 1992, 1993, 1996; Hoxby 1994a, b; or Grosskopf et al. 1999, 2000). Studies of competition in education base their estimates of the Herfindahl index or concentration ratio on enrollment shares, but expenditure shares are the name of the game outside of education (for example, Eberts and Gronberg 1990). Schneider (1989) measures competitive intensity using the number of contiguous jurisdictions and the standard deviations of expenditures and taxes for all cities in the metropolitan area. He argues that if all the jurisdictions offer the same bundle of taxes and services, there is no effective competition. Grossman, Mavros, and Wassmer (1999) use measures of jurisdictional size to capture the opposite idea— if city governments are too dissimilar, they do not compete. Borland and Howsen (1992, 1993, 1996) and Grosskopf et al. (1999, 2000) treat competition from public and private schools symmetrically using a Herfindahl index, but all other studies of the impact of private-sector competition use the private enrollment share as the measure of competition. Regardless of their metric for competitive pressure, virtually all the studies treat market structure as exogenous. The few exceptions come from the education literature and primarily arise from the obvious interplay between private school enrollment and public school quality (see Couch, Shughart, and Williams 1993; Dee 1998; and Hoxby 1994b). Hoxby (1994b) is the only researcher to model competition within the public sector as endogenous. She argues that jurisdictional boundaries were set historically following the topography of the land and that, therefore, topography can provide the exogenous variation needed for instrumental variables analysis. For each MSA, she records the number of “rivers, streams, creeks, inlets and similar bodies of water whose width exceeds 75 feet at some point and that extend at least five miles. They are classified as either inter-county ‘rivers’ (where they form county boundaries) or intra-county ‘rivers’ (where a stretch of water flows inside a county’s boundaries).” She then uses the number of intercounty rivers and the number of intra-county rivers, together with area demographics, to generate an instrumental variable for the Herfindahl index. She provides strong evidence that it can  governments within a small geographic unit like a county compete with equal intensity with one another, it is hard to argue that all governments within a large state or nation compete with one another in the short term. In most cases, a suburb of Dallas competes intensely with another Dallas suburb but only negligibly with a suburb of El Paso. Therefore, while all the governments may compete with one another in a geographically compact state like Connecticut, such a market definition is unlikely to fit properly for large states like Texas and California. Market concentration estimates based on geographic notions that fit some regions but not others will introduce systematic measurement error that makes the whole analysis suspect. Other researchers view only contiguous jurisdictions as relevant competitors (see, for example, Schneider 1989). Such studies probably define the market too narrowly and are particularly susceptible to spatial omitted variables masquerading as competition. For example, all governments near a prison may spend more on police than other governments. Most consistent with models of competition through factor migration are studies that use labor markets to define markets for government services (for examples, see Grosskopf et al. 1999, 2000; Eberts and Gronberg 1990; Hoxby 1994b; or Grossman, Mavros, and Wassmer 1999). Unfortunately, such studies tend to focus exclusively on horizontal competition with no regard for vertical competition among governments. While vertical competition may be negligible in certain markets (such as education services), it is potentially important in other markets (such as public safety). Another dimension of the market definition dilemma is the question of competition from the private sector. Although governments compete with the private sector to provide hospital care, health insurance, utilities, business financing, roads, security and detective services, and a myriad of other services, school districts are the only governments for which the literature examines external competition.7 The lack of evidence on the effects of external competition for noneducational services would be less troubling if the literature did not demonstrate so clearly that private-sector competition has a substantial influence on the one government that has been studied—public schools. The lack of consensus on market definition foreshadows the second weakness in the literature—idiosyncratic measures of competition. The most common measure is the number of governments deflated by some measure of  6  FEDERAL RESERVE BANK OF DALLAS  Political Competition While competition among government service providers has received most of the attention in the empirical economics literature, a modest, parallel literature explores the effects of competition for the political control of governments. In the political competition literature, citizens are usually treated as immobile, making the market for political control very different from the market for government services. Oversimplifying slightly, one can say that the political competition literature deals with voting, while the rest of the government competition literature deals with voting with your feet. The political competition literature has two main strands — voter monitoring and political concentration. Researchers have posited that governments that are difficult for voters to monitor or that are controlled by powerful political parties behave differently than do governments facing more political competition. The empirical literature generally supports this perspective. Although voter monitoring is not directly observable, rough proxies for increased monitoring are associated with smaller and more efficient governments. For example, Oates (1985) argues that centralized governments are more difficult for citizens to monitor, and, consistent with this perspective, researchers typically find that the public sector is bigger where the federal government is a larger share of total government. For examples, see Marlow (1988), Joulfaian and Marlow (1991), and Grossman and West (1994). For a counterexample, see Grossman’s (1992) analysis of Australia. Other proxies for monitoring activity include tax rates, population densities, home ownership rates, and the educational attainment of citizens. Such proxies partially explain variations in the efficiencies of police departments (Davis and Hayes 1993; Hayes and Wood 1995; and Hayes, Razzolini, and Ross 1998) and public schools (Grosskopf et al. 2000 and Duncombe, Miner, and Ruggiero 1997). Concentrated political power is usually associated with monopolistic behavior, although there is some debate as to whether monopolistic governments are necessarily nonoptimal (see Brown and Saving 1999). For example, Anderson and Tollison (1988) and Rogers and Rogers (1995) find evidence that governments are smaller in states where power is concentrated in one political party. Baber and Sen (1986) find that states with concentrated political power tend to have less of an increase in debtfinanced spending immediately prior to an election. Lipford and Yandle (1990) find that state governments make up a larger share of the public sector if a single party controls a larger share of the state government, a pattern they attribute to cartelizing by state legislatures. Although voting can substitute for voting with your feet, few empirical studies of competition among government service providers explicitly control for variations in political competition. Those studies that incorporate political competition do so through measures of monitoring rather than political concentration (see Grossman, Mavros, and Wassmer 1999; Grosskopf et al. 2000; Hayes, Razzolini, and Ross 1998; and Duncombe, Miner, and Ruggiero 1997). The studies tend to find that both types of competition enhance government efficiency.  be statistically inappropriate to treat market concentration as exogenous. As a general rule, Hoxby finds that when compared with ordinary least squares (OLS) analysis, an instrumental variables approach yields substantially larger estimates of market concentration’s effects on school-district size or student outcomes. However, in none of the cases she reports for comparison would a naive, OLS analysis have led a researcher to a conclusion other than Hoxby’s about the direction and significance of the effects of competition. An equally important problem of endogeneity arises from the possibility that there is a critical level of competition such that governments in markets on one side of the critical level would benefit from increased competition while those on the other side would not. All researchers who report looking for such a switching point have found one (see Grosskopf et al. 1999, 2000; Borland and Howsen 1993; and Zanzig 1997). For example, Grosskopf et al. (1999) estimate that school districts in metropolitan areas with a Herfindahl index above 0.27 (equivalent to a market with just over four equally large firms) are more than twice as allocatively inefficient as school districts in less concentrated markets. Unfortunately, as with the question of the general endogeneity of market concentration, this hypothesis has been explored only in the context of public education. Therefore, it is not clear whether the issue generalizes to other types of government. An ill-defined market, together with inconsistent and potentially inappropriate measuring sticks, raises the strong possibility that competition has been mismeasured in much of the literature on competition and government. Furthermore, there has been little empirical analysis of the contestability of the government market, of the extent to which the electoral process provides a substitute for competition from other government service providers (see the box entitled “Political Competition”), or of the extent to which variations in the regulatory environment selectively limit government responses to competitive pressure. Finally, for various reasons, the literature on government and competition has become overly concentrated in a single governmental function— education. Clearly, much work remains to be done on this issue. Most of the work on government responses to competition has focused on the market for education, and here the literature is strikingly consistent — competition improves public schools. Almost across the board, re-  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  searchers have found that school spending is lower, academic outcomes are better, and school-district efficiency is higher where parents have more choice in their children’s educational provider. Furthermore, competitive benefits emerge regardless of whether the competitor is a private school or another public school. Thus, the literature offers support for the notion that increased school competition— fostered either by vouchers or charter schools—would improve the public school system. Additional research will be necessary, however, before this conclusion can be extended to the remainder of the public sector.  7  of Public School Spending” (Paper presented at the American Education Finance Association Meeting, Austin, Texas, March 9 –11).  NOTES  1  2  3  4  5  6  7  Thanks to Stephen P. A. Brown, Kathy J. Hayes, Jason Saving, and Pia Orrenius for helpful comments. Of course, any remaining errors are my own. A parallel literature explores political competition (see box on page 7). Other literatures explore government competition less directly. For example, a substantial literature uses housing values to examine whether governments are efficient (see Oates 1969, Hoyt 1990, Taylor 1995, and Brueckner 1982), while another literature explores the interdependence of government decisionmaking (see Figlio, Kolpin, and Reid 1999; Case, Rosen, and Hines 1993; Staley and Blair 1995; and Blair and Staley 1995). Schneider (1989) and Joulfaian and Marlow (1991) use government employment per capita to measure government size. Schneider also examines the relationship between competition and public-sector wages. His wage analyses are inconclusive. In this context, the Herfindahl index is the sum of squared enrollment shares. Borland and Howsen include competition from private schools in their Herfindahl index. As such, the index measures the effects of competition without regard to whether the competition is horizontal or external. However, Newmark (1995) examines the robustness of the results in Couch, Shughart, and Williams (1993) and concludes that their analysis is fragile. See Couch and Shughart (1995) for their response. See, for example, Oates 1985; Nelson 1986, 1987; Zax 1989; Heil 1991; Kenny and Schmidt 1994; Di Matteo 1995; Bell 1988; Borland and Howsen 1992, 1993, 1996; Zanzig 1997; or Grossman 1989. A substantial literature compares the relative efficiency of public and private service providers but does not answer the question, Would fostering private competition improve public service quality, cost, or efficiency?  Bell, Christopher Ross (1988), “The Assignment of Fiscal Responsibility in a Federal State: An Empirical Assessment,” National Tax Journal 41 (June): 191– 207. Blair, John P., and Samuel R. 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Hines, Jr. (1993), “Budget Spillovers and Fiscal Policy Interdependence: Evidence from the States,” Journal of Public Economics 52 (October): 285 – 307.  Baber, William R., and Pradyot K. Sen (1986), “The Political Process and the Use of Debt Financing by State Governments,” Public Choice 48 (3): 201–15.  Couch, Jim F., and William F. Shughart II (1995), “Private School Enrollment and Public School Performance: Reply,” Public Choice 82 (March): 375 – 79.  Barrow, Lisa, and Cecilia Elena Rouse (2000), “Using Market Valuation to Assess the Importance and Efficiency  8  FEDERAL RESERVE BANK OF DALLAS  Couch, Jim F., William F. Shughart II, and Al L. Williams (1993), “Private School Enrollment and Public School Performance,” Public Choice 76 (August): 301–12.  Grossman, Philip J., and Edwin G. West (1994), “Federalism and the Growth of Government Revisited,” Public Choice 79 (April): 19 – 32.  Davis, Michael L., and Kathy Hayes (1993), “The Demand for Good Government,” Review of Economics and Statistics 75 (February): 148 – 52.  Hayes, Kathy J., Laura Razzolini, and Leola B. Ross (1998), “Bureaucratic Choice and Nonoptimal Provision of Public Goods: Theory and Evidence,” Public Choice 94 (January): 1– 20.  Dee, Thomas S. (1998), “Competition and the Quality of Public Schools,” Economics of Education Review 17 (October): 419 – 27.  Hayes, K., and L. L. Wood (1995), “Utility Maximizing Bureaucrats: The Bureaucrat’s Point of View,” Public Choice 82 (January): 69 – 83.  Di Matteo, Livio (1995), “Fiscal Centralization at the Provincial Local Level in Canada, 1961–1991,” Canadian Tax Journal 43 (3): 639 – 59.  Heil, James B. (1991), “The Search for Leviathan Revisited,” Public Finance Quarterly 19 (July): 334 – 46.  Duncombe, William, Jerry Miner, and John Ruggiero (1997), “Empirical Evaluation of Bureaucratic Models of Inefficiency,” Public Choice 93 (October): 1–18.  Hoyt, William H. (1990), “Local Government Inefficiency and the Tiebout Hypothesis: Does Competition Among Municipalities Limit Local Government Inefficiency?” Southern Economic Journal 57 (October): 481– 96.  Eberts, Randall W., and Timothy J. Gronberg (1988), “Can Competition Among Local Governments Constrain Government Spending?” Federal Reserve Bank of Cleveland Economic Review 24 (1): 2 – 9.  Hoxby, Caroline Minter (1994a), “Do Private Schools Provide Competition for Public Schools?” NBER Working Paper Series, no. 4978 (Cambridge, Mass.: National Bureau of Economic Research, December).  ——— (1990), “Structure, Conduct, and Performance in the Local Public Sector,” National Tax Journal 43 (June): 165–73.  ——— (1994b), “Does Competition Among Public Schools Benefit Students and Taxpayers?” NBER Working Paper Series, no. 4979 (Cambridge, Mass.: National Bureau of Economic Research, December).  Figlio, David N., Van W. Kolpin, and William E. Reid (1999), “Do States Play Welfare Games?” Journal of Urban Economics 46 (November): 437– 54.  Husted, Thomas A., and Lawrence W. Kenny (1996), “Efficiency in Education: Evidence from the States,” Proceedings of the 89th Annual Conference on Taxation (Washington, D.C.: National Tax Association).  Forbes, Kevin F., and Ernest M. Zampelli (1989), “Is Leviathan a Mythical Beast?” American Economic Review 79 (June): 568 – 77. Grosskopf, Shawna, Kathy J. Hayes, Lori L. Taylor, and William L. Weber (1999), “Allocative Inefficiency and School Competition,” Proceedings of the 91st Annual Conference on Taxation (Washington, D.C.: National Tax Association).  Joulfaian, David, and Michael L. Marlow (1991), “Public Sector Employment, Competition, and Government Size,” Public Finance 46 (2): 222 – 35. Kenny, Lawrence W., and Amy B. Schmidt (1994), “The Decline in the Number of School Districts in the U.S.: 1950 –1980,” Public Choice 79 (April): 1–18.  ——— (2000), “On the Determinants of School District Efficiency: Competition and Monitoring,” manuscript.  Lipford, Jody, and Bruce Yandle (1990), “Exploring Dominant State Governments,” Journal of Institutional and Theoretical Economics 146 (December): 561– 75.  Grossman, Philip J. (1989), “Federalism and the Size of Government,” Southern Economic Journal 55 (January): 580 – 93.  Marlow, Michael L. (1988), “Fiscal Decentralization and Government Size,” Public Choice 56 (March): 259 – 69.  ——— (1992), “Fiscal Decentralization and Public Sector Size in Australia,” Economic Record 68 (September): 240 – 46.  Nelson, Michael A. (1986), “An Empirical Analysis of State and Local Tax Structure in the Context of the Leviathan Model of Government,” Public Choice 49 (3): 283 – 94.  Grossman, Philip J., Panayiotis Mavros, and Robert W. Wassmer (1999), “Public Sector Technical Inefficiency in Large U.S. Cities,” Journal of Urban Economics 46 (September): 278 – 99.  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  ——— (1987), “Searching for Leviathan: Comment and Extension,” American Economic Review 77 (March): 198–204.  9  Newmark, Craig M. (1995), “Another Look at Whether Private Schools Influence Public School Quality: Comment,” Public Choice 82 (March): 365 –73.  Schneider, Mark (1989), “Intercity Competition and the Size of the Local Public Work Force,” Public Choice 63 (December): 253 – 65.  Oates, Wallace E. (1969), “The Effects of Property Taxes and Local Spending on Property Values: An Empirical Study of Tax Capitalization and the Tiebout Hypothesis,” Journal of Political Economy 77 (November/December): 957–71.  Staley, Samuel R., and John P. Blair (1995), “Institutions, Quality Competition and Public Service Provision: The Case of Public Education,” Constitutional Political Economy 6 (Winter): 21– 33. Taylor, Lori L. (1995), “Allocative Inefficiency and Local Government,” Journal of Urban Economics 37 (March): 201–11.  ——— (1985), “Searching for Leviathan: An Empirical Study,” American Economic Review 75 (September): 748 – 57.  Tiebout, Charles (1956), “A Pure Theory of Local Expenditure,” Journal of Political Economy 64: 416 – 24.  ——— (1989), “Searching for Leviathan: Reply,” American Economic Review 79 (June): 578 – 83.  Zanzig, Blair R. (1997), “Measuring the Impact of Competition in Local Government Education Markets on the Cognitive Achievement of Students,” Economics of Education Review 16 (October): 431– 44.  ——— (1999), “An Essay on Fiscal Federalism,” Journal of Economic Literature 37 (September): 1120 – 49. Rogers, Diane Lim, and John H. Rogers (1995), “Political Competition, Causal Relationships Between Taxes and Spending and Their Influence on Government Size: Evidence from State-Level Data,” International Finance Discussion Paper no. 500, Federal Reserve Board of Governors.  Zax, Jeffrey S. (1989), “Is There a Leviathan in Your Neighborhood?” American Economic Review 79 (June): 560 – 67.  Santerre, Rexford E. (1991), “Leviathan or Median Voter: Who Runs City Hall?” Eastern Economic Journal 17 (January – March): 5 –14.  10  FEDERAL RESERVE BANK OF DALLAS  Over the past decade the U.S. banking industry has undergone many changes, including the resolution of the savings and loan bailout, the rise of Internet banking, numerous mergers and acquisitions, and financial deregulation. Although all of these have had, or will have, a major impact on the banking sector, two of these factors could alter the underlying structure of the U.S. banking system. The first is the flurry of mergers and acquisitions that has occurred; the second is the passage of the Gramm–Leach–Bliley Financial Services Modernization Act (Senate Bill 900) on November 12, 1999. Like much of the industrialized economy, in the past few years the U.S. banking sector has experienced numerous mergers and acquisitions. Several mergers involved the country’s largest banks, most notably the combinations of Citicorp and Travelers Group, Banc One and First Chicago, and NationsBank and BankAmerica. This consolidation trend has not been confined to the United States; there have been numerous mergers in such countries as Japan, France, and Germany, as well as crosscountry mergers such as that of Deutsche Bank and Bankers Trust (Table 1 ). Although in terms of dollar value mergers peaked in the United States in 1998, there continues to be considerable consolidation activity (Table 2 ). Its impact on the degree of competition and on the industry’s structure both here and abroad is of concern to both economists and regulators. The Financial Services Modernization Act, the other factor that could alter the industry’s underlying structure, essentially repealed the Banking Act of 1933, more commonly called the Glass – Steagall Act. Glass – Steagall separated commercial banking, insurance, and investment banking into three distinct businesses that were prohibited from engaging in each other’s activities. For example, banks could not offer insurance or underwrite securities. Although the legal barriers between these sectors had eroded over time, banks were still prevented from completely entering the other two businesses.1 By lifting these statutory barriers, the new legislation could accelerate the merger of firms across the financial services industry (in contrast to the recent mergers within the banking sector). This could also lead to a less competitive financial and banking sector. These two events, and the resulting consolidation, highlight the importance of understanding how this sector’s structure (that is, the degree to which it is competitive) impacts various aspects of the economy and future economic  The Economic Impact of Bank Structure: A Review of Recent Literature Mark G. Guzman  T  he recent passage of the  Financial Services Modernization Act, along with numerous bank mergers over the past few years, has focused attention on the banking system in general and on the sector’s industrial organization in particular.  Mark G. Guzman is an economist in the Research Department at the Federal Reserve Bank of Dallas.  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  11  Table 1  Recent Merger Activity of World’s Largest Banks 1998 assets (in billions of U.S. dollars) Mizuho Financial Group  1,342,351  Mergers and acquisitions Industrial Bank of Japan and Dai Ichi Kangyo and Fuji Bank* Sumitomo Bank and Sakura Bank †  Sumitomo Bank/Sakura Bank  877,977  Mitsubishi Tokyo Financial Group  804,008  Bank of Tokyo and Mitsubishi Bank and Mitsubishi Trust and Bank †  Deutsche Bank  735,808  Sanwa Bank/Tokai Bank  694,114  Deutsche Bank and Bankers Trust Sanwa Bank and Tokai Bank †  BNP Paribas  692,713  BNP and Paribas  United Bank of Switzerland  687,316  Union Bank of Switzerland and Swiss Bank  Citigroup  668,641  Citicorp and Travelers Group  Bank of America  617,679  NationsBank and BankAmerica  HypoVereinsbank  541,032  Hypo-Bank and Bayerische Vereinsbank  * Scheduled for completion in 2002. † Scheduled for completion in 2001. SOURCES: 1999 Fortune Global 500; Dow Jones Interactive; Federal Reserve Board of Governors.  growth. This, along with recent empirical work showing the importance of financial market development for economic growth, has generated research aimed at determining the macroeconomic impact resulting from differences in the industrial organization of the banking system. There is no single, simple answer to this question. Thus, this article focuses on some of the theoretical research examining how the banking sector’s underlying structure affects the economy and economic growth.  related models based on utility and profit maximization rather than on assumptions of the resulting behavior. Their models focus primarily on the part asymmetric information plays in the allocation of resources.4 Much of the subsequent research in this area focuses on banks’ and financial markets’ role in helping overcome information gaps between borrowers and lenders. With the work of Townsend and Stiglitz and Weiss as a foundation, Diamond (1984), Gale and Hellwig (1985), Boyd and Prescott (1986), and Williamson (1986, 1987) developed theoretical frameworks that model financial intermediaries more explicitly. Banks arise naturally in these models as a means for overcoming asymmetric information problems. The particular form of this problem is that it is costly for lenders (or banks) to obtain information about borrowers and their projects. In these models, banks possess economies of scale with respect to gathering information and monitoring firms and thus are more efficient (or more cost-effective) than individual investors could be. Until the early 1990s, most of the research focused primarily on a theoretical understanding of the relationship between banks and borrowers and justifying the existence of banks within the framework examined—that is, what services a bank could provide that individuals could not accomplish for themselves. However, in the 1990s theoretical and empirical research returned to  AN OVERVIEW OF THE LITERATURE Economists have long recognized that financial markets in general, and banks in particular, play a vital role in the efficient functioning and development of any economy.2 Some of the recent research examining the relationship between banks, financial markets, and the macroeconomy have their origins in early work by Cameron (1967), Goldsmith (1969), McKinnon (1973), and Shaw (1973).3 These authors highlight the fact that financial markets affect, and in turn are affected by, economic growth. They argue that well-developed financial markets are necessary for the overall economic advancement of less developed countries. Townsend (1979) and Stiglitz and Weiss (1981) represent the next major work in this area. They developed some of the first banking-  12  FEDERAL RESERVE BANK OF DALLAS  Table 2  Value of Recent U.S. Mergers Assets of acquired banks (in billions of U.S. dollars)  Acquired banks Total for 1998 Largest mergers Travelers Group NationsBank Bank One Total for 1999 Largest mergers Deutsche Bank Fleet Financial HSBC Holding  1,016,565 Citicorp BankAmerica and Barnett First Chicago and First Commerce  310,897 304,164 132,407 309,749  Bankers Trust BankBoston and Matewan Bancshares Republic New York  156,267 76,392 50,453  NOTES: 1999 total is for mergers completed as of November 30. The HSBC/Republic merger is pending. SOURCE: Federal Reserve Board of Governors.  the focus of the late 1960s and early 1970s, more closely examining the relationship between the financial sector and economic growth. Recent empirical work on this relationship has established a strong, positive association between the development of a formal financial sector and an economy’s level (or rate of growth) of real activity. King and Levine (1993b) establish that the banking sector’s development is not only correlated with economic growth but is also a cause of long-term growth. Subsequent work has refined King and Levine and established that financial markets (defined more broadly than in their work) are a source of economic growth.5,6 In addition, a theoretical literature exploring the nature of the correlation between the banking sector and economic growth has developed. It suggests that the financial system could impact real economic performance by affecting the composition of savings (Bencivenga and Smith 1991), providing information (Greenwood and Jovanovic 1990), and affecting the scope for credit rationing (Bencivenga and Smith 1993; Boyd and Smith 1997, 1998).7 However, most of the theoretical literature on the relationship between intermediation and growth considers an economy with a competitive banking system. As a practical matter, economies display substantial variation in the competitive environment of their banking systems. Table 3 provides an approximate measure —concentration ratios —for the degree of competition within various countries’ banking sectors. Ascertaining the actual level of competitive-  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  ness within the industry is extremely difficult. Consequently, concentration ratios (the fraction of the banking market served by the largest four or five banks) are often used as a proxy to measure competitiveness. It should be noted that these ratios are an imperfect measure, as even if the largest banks control most of the market, they still might compete fiercely among themselves. As a result of these differences, more recent theoretical research has begun examining the banking sector’s market structure along two lines. The first, characterized by Krasa and Villamil (1992) and Winton (1995), examines the optimal size, number, and capitalization of banks. Although these studies deal somewhat with bank structure, they focus primarily on the optimal size of banks when risk exists in the environment—that is, when portfolio risk cannot be completely diversified away. The second line of research focuses on comparing economies that are identical except for the structure of the banking system. These models examine the impact bank structure has on some particular aspect of the economy. Thus, they assume a particular market structure (either competitive banks or a monopoly bank), as opposed to ascertaining the optimal bank size and number. It is this line of research that this article explores. BANK STRUCTURE AND THE ECONOMY To examine the economic impact of a banking system’s structure, most theoretical  13  also applies to the banking sector. One would expect a monopoly bank to make fewer loans and to have higher service fees, higher interest rates on loans, and lower interest rates on deposits than a competitive bank. However, the idea that a monopoly is only detrimental to an economy is predicated on the existence of complete markets and complete information. In the real world neither markets nor information tends to be complete. This is especially true of financial markets and the banking industry. Unlike many businesses, banks do not produce physical goods but, rather, provide the financial means for production. One of the biggest problems the banking sector faces is a lack of information about both the individuals requesting funds and the projects they propose to undertake with the loans. This asymmetric information leads to problems of adverse selection—choosing the most profitable borrowers —and moral hazard—convincing borrowers to use funds in less risky ways. These inherent problems, which are difficult for a competitive banking system to overcome, can be eased or eliminated by a monopolistic (or oligopolistic) banking system. However, for a complete comparison between economies with different banking system structures, the gains from a monopolistic system must be weighed against the losses mentioned above. The recent literature can be divided into two groups, based on the economic framework used: partial equilibrium models and general equilibrium models. The partial equilibrium models focus on some particular aspect of the bank–borrower relationship and ascertain how the market structure of the banking system impacts it. Generally, these models do not take into account all major aspects of banks—in particular, they tend to ignore the deposit side of banking—nor are they concerned with the overall economic impact of the particular banking structure. However, they illustrate the point that a monopoly bank can be beneficial in that it helps overcome the problems associated with asymmetric information. The general equilibrium models also focus on one particular aspect of the bank– borrower relationship. However, these models also consider the deposit side of banking and are concerned with the overall economic impact of the banking system. Thus, they are better for ascertaining whether the costs outweigh the benefits of a monopoly bank. One consequence of being able to examine both the costs and benefits is that the relationship between borrowers and banks is often modeled with less richness and  Table 3  Structure of the Banking Industry at Year-End 1998 Concentration in the banking industry (percent) China India Hong Kong Korea Malaysia Philippines Singapore Thailand  70 42 29 50 40 60 39 62  Argentina Brazil Chile Colombia Mexico Peru Venezuela  38 52 47 53 68 67 56  Czech Republic Hungary Poland Russia  66 57 43 42  Israel Saudi Arabia South Africa  87 66 81  Australia Germany Japan United States  69 17 22 35  NOTES: Concentrations are the five largest banks’ assets as a percentage of total banking system assets, except for China, which is the four largest banks’ assets. Poland rose to 51 percent on January 1, 1999. SOURCE: Bank for International Settlements (1999).  models compare economies with competitive banking systems with those having monopolistic systems.8 Although few, if any, banking systems are true monopolies, comparing these two extremes sheds light on how the degree of competition in the banking system affects the economy. It is well understood that monopolies tend to reduce an economy’s overall social welfare. They charge higher prices and produce less than optimal amounts of goods and services, they stifle invention and innovation, and they distort resource allocation, all of which reduce capital accumulation and growth. This characterization of the negative aspects of a monopoly  14  FEDERAL RESERVE BANK OF DALLAS  forming such ties diminish as markets become more competitive? The questions arise from the idea established in the labor literature that competition and long-term relationships are incompatible.11 The authors also empirically study the U.S. small business market, as bank finance and the degree of competition vary at the local level in this market. They find that less competition in the banking industry leads to more firms obtaining loans, and they obtain these loans at a lower cost. Petersen and Rajan employ a static, threeperiod model, with two classes of borrowers — those with good project returns and those with bad project returns. Bad-return borrowers who borrow in the initial period (at date 0) will receive a return of zero in the following period (at date 1). Good-return borrowers have two projects in which they can invest, hence the moral hazard in the model. They have access to both a risky and a riskless technology. The risky project has a higher return than the riskless project with some given probability; otherwise it returns nothing. Any returns from the initial project are used to partially finance subsequent investment projects. However, in spite of possessing some initial capital, the good-return entrepreneur must also borrow to fully fund a project in the next period (at date 1). Banks are the only source of funding in the economy. At date 0, banks are unable to differentiate between good- and bad-return borrowers. At the beginning of date 1, all borrowers’ types are revealed, and thus loans at this date are only made to good-return borrowers. It is assumed contracts take the form of debt contracts. Finally, this model does not address how the deposits needed to make the loans are obtained. In equilibrium banks will offer two sequential one-period loan contracts as opposed to one two-period contract. This stems from both the adverse selection problem experienced at date 0, as well as the moral hazard problem pertaining to good-return borrowers at both dates 0 and 1. If the bank offers a two-period contract, the result will be higher interest rates on loans, relative to two one-period contracts, at date 0 in an attempt to cover potential losses from loans to bad-return borrowers. This higher rate exacerbates the moral hazard problem, which can lead to credit rationing by the bank. The bank can minimize these problems by offering two sequential one-period debt contracts. In addition, good-return borrowers will borrow as little as possible at date 0 to differentiate themselves from bad-return borrowers. This will also reduce borrowing costs in the  detail. The next sections describe six recent studies and detail some of the theoretical benefits and costs associated with a monopolistic banking system.9 Partial Equilibrium Models To illustrate the benefits of a monopoly bank, it is useful to begin with a review of recent partial equilibrium models. These models deal with the basic problem of asymmetric information between banks and borrowers— adverse selection and moral hazard—in several standard ways. Numerous theoretical models address the problems of adverse selection and the economic implications of banks’ inability to distinguish between different classes of potential borrowers. Generally, there are two primary methods by which banks determine creditworthiness: screening of potential borrowers prior to making a loan and inducing borrowers to reveal the true nature of their investment project. In models where a bank screens potential borrowers, it gathers the information needed to determine (usually under the assumption of certainty) whether the borrower’s investment project will produce a good or bad return. However, screening is costly in that it consumes resources and profits. Alternatively, the bank can induce borrowers to truthfully state whether their investment projects’ returns are expected to be good or bad. This is usually accomplished by the choice of contract terms and the interest rates on loans or by rationing credit to their projects.10 Moral hazard is the other primary problem that arises between borrowers and lenders. When the borrower has several investment choices, it is in the bank’s interest to induce the borrower to undertake the project that is less risky and more likely to have a positive return. Of the three studies discussed in this section, Petersen and Rajan (1995) and Schnitzer (1998a) consider the problems of both adverse selection and moral hazard, whereas Caminal and Matutes (1997) make the moral hazard problem paramount. Petersen and Rajan rely on inducing borrowers to take appropriate actions, while Schnitzer relies on screening to overcome the asymmetric information problem. Caminal and Matutes use both techniques. Long-term Relationships, Credit Rationing, and Banks. Petersen and Rajan (1995) are particularly interested in understanding the long-term relationships between banks and businesses. They ask two questions: Can firms facing competitive credit markets form strong ties with a particular creditor? And do the benefits from  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  15  Figure 1  subsequent period. Finally, banks will structure loans and interest rates so that they induce the good-return borrowers to choose the less risky project and so that banks can recoup all costs associated with lending at all dates. The authors demonstrate that as market power increases, firms with lower credit quality are able to obtain funding. The intuition is that as market power increases, it is easier for banks to extract more surplus from firms in subsequent periods. This can also be viewed as banks implicitly taking an equity stake in firms. Petersen and Rajan also show that as market power increases, the initial interest rate offered to the lowest-quality firms obtaining financing becomes lower than that in a purely competitive banking system. Thus, greater financing to more firms is achieved as the banking system becomes less competitive. The authors conclude by empirically investigating these theoretical results using U.S. small business data.12 Bank Structure and Bank Solvency. The second partial equilibrium model, Caminal and Matutes (1997), explores the relationship between market structure and the solvency of the banking sector. The authors’ reason for investigating the linkage is the recent deregulation in the banking and financial markets. They note that one of the primary goals of this deregulation has been to improve the efficiency of banks by increasing competition between them. However, it is often argued that too much competition can jeopardize the solvency of the entire banking system.13 Caminal and Matutes show that a monopoly bank will raise the volume of loans (and thus, the volume of risky loans) to certain borrowers while decreasing the volume of (risky) loans to other borrowers. Thus, they are unable to draw clear-cut conclusions about the relationship between market structure and solvency. The basic model is static and incorporates market uncertainty, asymmetric information, and moral hazard. Moral hazard, the primary problem, arises because borrowers can choose from a range of production technologies. Caminal and Matutes incorporate asymmetric information and economic uncertainty into their theoretical framework in three ways. First, informational asymmetries can be reduced either by monitoring or by rationing credit. By monitoring, the authors mean the bank can choose and supervise the production technology the firm uses. Monitoring, therefore, is conducted prior to making the loan and has the flavor of the German banking system, in which banks have seats on the boards of businesses to which they  Time Line of Contract Between Bank and Borrower  Bank offers interest rate  Bank learns cost of monitoring; decides whether to monitor  Bank decides maximum amount it will lend borrower  Borrower can make counteroffer  Bank accepts/ rejects counteroffer  Borrower chooses loan size  Monitored: bank chooses production technology  Not monitored: borrower chooses production technology  Production  Repayment  make loans. In addition, monitoring is costly and borrower-specific. Thus, monitoring is a costly way to eliminate the moral hazard problem inherent in this model. In lieu of monitoring, a bank may ration credit by providing smaller loans than borrowers desire. However, credit rationing and monitoring are not perfect substitutes. If the bank monitors, there obviously is no reason to ration credit (and thus the loan size will be larger than without monitoring). When the bank rations  16  FEDERAL RESERVE BANK OF DALLAS  credit, it does so to induce borrowers to choose a less risky production technology.14 The final aspect of the model relates the size of a loan to its level of riskiness. The larger the loan, the riskier it will be. This stems from the assumption that a borrower’s return depends on both the size of the loan and a multiplicative aggregate shock. The contract between the bank(s) and borrowers develops in stages (Figure 1 ). First, the bank offers an interest rate and the guarantee that neither it (nor the firm) will be forced to lend (or borrow) more than either party would like. Next, the bank learns the cost of monitoring and decides whether to monitor. The bank then offers a maximum loan amount. At this point, the firm can attempt to renegotiate the interest rate, the loan size, or both. After the success (or failure) of any renegotiations, the firm chooses the size of loan, given the agreedupon interest rate. Finally, the production technology is chosen (by the bank if monitoring or by the borrower if not), production is undertaken, and repayment is made according to the contract. All contracts between banks and borrowers are assumed to be standard debt contracts. As with Petersen and Rajan, the deposit side is ignored and it is assumed a bank can obtain as much in deposits as needed to make loans, at a cost that is not prohibitive. Caminal and Matutes show that market power in banking raises the interest rate on loans, which has two repercussions. First, for a given level of monitoring, the higher the interest rate, the worse the incentive problem. This, in turn, results in a tightening of credit and smaller loans to the credit-constrained group. However, higher interest rates will also lead the bank to increase monitoring, which will reduce the proportion of credit-constrained borrowers. Thus, the higher interest rate associated with a monopoly bank has two, opposite effects on the volume of loans. More borrowers (and more risky borrowers) will receive loans due to the increase in monitoring. This is offset by the fact that those who are credit-constrained receive smaller loans than they otherwise would. This ambiguity about monopoly banking’s impact on total loan volume leads to ambiguity about the relationship between market power and banking system solvency. The greater the volume and the larger each individual loan, the greater the probability of a bank failure. The number of loans to those who are not creditrationed increases, implying that bank failure is more likely, while the size of the loans to those who are credit-rationed decreases, implying that  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  failure is less likely. Consequently, it is impossible to draw a clear-cut conclusion about the relationship between the structure and the solvency of the banking system. Screening Borrowers, Restructuring Firms, and Banks. The partial equilibrium model by Schnitzer (1998a) examines how banks use screening in deciding loan disbursement.15 Schnitzer evaluates the economic prospects of firms in transition economies, particularly those of Eastern Europe. Although not directly interested in how banking sector structure impacts the economy, she argues that banks in transition economies play a fundamental role in the financing, monitoring, and restructuring of firms.16 Consequently, she addresses two questions. First, how does the market structure of the banking sector impact the screening process for obtaining financing? Second, how does banking structure affect the likelihood of restructuring by a firm’s manager? Her results are mixed in that a competitive banking sector will result in too little screening but more restructuring than a monopolistic system. There are two agents in Schnitzer’s economy: a firm and either a monopoly bank or two banks acting as Bertrand competitors.17 The firm has an investment project with uncertain return that must be financed with credit. The return to the investment is either good, with some given probability, or it is bad. There is no moral hazard problem with respect to the operation of the project. Banks, the only source of financing in the economy, must decide whether to screen borrowers and then to whom to give loans. Screening is costly but perfectly reveals whether the investment is good or bad. It is assumed the cost of screening is low enough that the returns from lending only for good projects exceed the costs of screening. Finally, how banks obtain the deposits necessary to make loans is not modeled. It is assumed that the banks can obtain sufficient deposits to fund all borrowers and that the cost of obtaining these funds is not prohibitive. A monopoly bank in this economy always screens. The cost of screening is assumed to be less than the expected losses from making loans for bad-return projects; thus, the bank will only make loans for good-return projects. The bank will set the interest rate sufficiently high that it extracts all surplus from the investment projects. These results are compared with those from an economy with two banks engaged in Bertrand competition. The competitive banking scenario is further divided into two cases: one where screening produces informational spill-  17  overs and one where it does not. In the first case, because of the informational spillovers, if either bank screens and ascertains the borrower’s particular project return, this information becomes public knowledge. In this case, neither bank will engage in screening because there exists a classic free rider problem. Thus, in equilibrium both good- and bad-return borrowers will obtain financing as banks randomly make loans. This is inferior to the equilibrium with a monopoly bank because, by assumption, the losses associated with loans to bad projects exceed the costs of screening. In the second case, informational spillovers do not exist—that is, screening produces private information. Under this condition three equilibria exist. One is an (unique, mixed strategy) equilibrium where both banks screen with some positive probability. There are also two (symmetric, pure strategy) equilibria where one bank screens and the other does not. All of these equilibria are less efficient than the monopoly bank because either banks duplicate screening costs or, as before, losses from lending without screening exceed the costs of screening. Thus, screening technology is most efficiently used in an economy with a monopolistic banking system. Schnitzer also shows that a competitive system is more likely to lead to firms restructuring. In her model, restructuring is defined as the manager spending some unobservable effort attempting to make the project more profitable and results in one of two outcomes. Either the effort, which is decided upon before credit offers or screening, can raise the probability that the project will generate a good return, or it can increase the project’s return. In either case, restructuring only occurs when the banking system is competitive. This is because under a competitive system, the manager is able to keep part of the increased returns resulting from his or her efforts. With a monopoly bank, the bank confiscates any extra return (by choice of interest rate), and thus, the manager lacks the incentive to undertake restructuring. Remarks. Although each of the three studies discussed examines different aspects of the bank–borrower relationship, all find that monopoly in banking may be economically beneficial because of the bank’s ability to overcome problems related to adverse selection and moral hazard. However, there are two important caveats. First and foremost, since these are partial equilibrium models, they do not take into account all the economic effects of bank structure. Their conclusion—that monopoly may be beneficial—is limited to the specific problem  each study examines and does not imply the benefits from a monopoly outweigh all the costs. In addition, all the models focus only on the bank –borrower relationship and ignore the deposit side of banking —an important omission that may affect the results. General Equilibrium Models The remaining three models — Cetorelli (1997), Smith (1998), and Guzman (forthcoming)—are general equilibrium (and overlapping generations) models. As a result, they allow for an exploration of the deposit side of banking and its potential constraint on the lending side, as well as for an examination of monopoly’s detrimental impact on capital accumulation and growth. However, as a trade-off for a general equilibrium framework, they do not model the interaction of banks and borrowers with as much richness as some of the partial equilibrium models. For example, they all ignore the possibility of moral hazard and deal only with the problem of adverse selection. Screening and Banks Revisited. Like Schnitzer, Cetorelli (1997) investigates how the structure of the banking system affects the screening process.18 However, unlike the first three models discussed, the equilibrium achieved with a monopolistic banking system is not necessarily superior to (Pareto dominates) the equilibrium from a competitive system. Cetorelli’s results differ from Schnitzer’s because he employs a general equilibrium model that takes into account monopoly profits’ negative impact on capital accumulation. Cetorelli notes that many countries—such as the United States during the Civil War, postwar Japan, and European countries in the nineteenth century—seem to have experienced enhanced growth in periods during which the financial sector was less competitive and more concentrated. This observation forms the basis for the question Cetorelli investigates: How does credit market competitiveness impact economic growth? The basic economic model Cetorelli uses is a standard Diamond (1965) overlappinggenerations model with production. However, production is a two-stage process, where in the first stage, potential entrepreneurs attempt to set up a project. If they succeed, in the next stage they produce goods after renting capital and labor. To set up a project, entrepreneurs are required to borrow funds from banks. At the beginning of each period, every young individual is a potential entrepreneur. The young can further be divided into two groups: those entrepreneurs with good project returns —who will  18  FEDERAL RESERVE BANK OF DALLAS  succeed with some given probability — and those with bad project returns —who will be unsuccessful. If unsuccessful in starting a project, the individual provides labor in the second stage of production. Banks are the only entities that provide credit for stage one of production. It is argued that banks will naturally arise due to economies of scale with respect to both diversification across borrowers and with respect to the screening process. As with Schnitzer, screening is costly, but it does provide perfect information about an entrepreneur’s type (either good or bad project returns). Cetorelli further assumes that once an individual is screened, there are perfect informational spillovers and all banks in the economy know his or her type. Finally, screening costs are not constant and are, in fact, proportional to the amount of saving. Cetorelli compares two economies —one with Bertrand competitors and the other with a monopoly bank — in terms of capital accumulation and steady-state levels of the capital stock. Bertrand competition, in conjunction with the perfect informational spillovers associated with screening, renders screening economically infeasible; as before, a free rider problem exists. A monopoly bank, in contrast, will always screen as screening costs are lower than the losses from lending to bad-return entrepreneurs. Consequently, because a monopoly bank screens and is thus more efficient in the loans it makes, capital accumulation will be greater. However, there is also a downside to the monopoly bank. It is assumed bank profits are consumed by the bank and not rebated to any individuals in the economy. Thus, instead of these profits being used to create future capital, as is the case with a competitive banking system, they are lost to the economy. It is not obvious which of these forces —efficiency gains from screening or production losses from profits— will dominate and, consequently, whether a monopoly bank benefits the economy. Cetorelli also examines the model’s comparative statics to ascertain the conditions under which a monopoly bank would definitely lead to greater capital accumulation than a competitive system would. He finds that given a sufficiently low proportion of high-quality entrepreneurs and other conditions — such as low screening costs, high savings elasticity, and low loan-demand elasticity — capital accumulation and growth will be greater with a monopoly bank. Finally, Cetorelli also discusses in what types of countries these conditions are likely to prevail.  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  Bank Solvency Revisited. Smith (1998) focuses on how monopoly in banking affects both income levels and the likelihood of dramatic swings in the business cycle. His impetus is similar to that of Caminal and Matutes; he observes that the stability of the banking industry appears to be enhanced when only a limited number of banks exert significant market power. This market power is often the result of regulatory barriers enacted by various governmental bodies. Smith shows that a competitive banking system will result in a higher level of income and output and in a reduction in the severity of the business cycle. Like Cetorelli, Smith uses a standard Diamond (1965) overlapping-generations model with production. In addition, production is subject to stochastic shocks. There are two types of individuals in the economy: lenders and entrepreneurs. Lenders have three ways to save for old age. They can allocate their wage income to direct, bilateral loans to an entrepreneur, to deposits at a bank, or to investments in a storage technology. Entrepreneurs can either save their income by one of these means, or they can invest it in a risky project.19 Entrepreneurs fall into three categories: those who do not need to borrow to fund a project, those who need to borrow less than half the start-up cost of the project, and those who need to borrow more than half the project’s start-up cost. Borrowers have two sources of financing: banks and direct, bilateral (unintermediated) loans.20 Banks and individual lenders are assumed to act as Bertrand competitors. Although the model allows for bilateral contracts, in equilibrium they are not chosen. However, they are important to the model in that they limit a monopoly bank’s power to impose any interest rate it chooses—that is, they place an upper bound on interest rates. Consequently, banks are the only channel for transferring funds from lenders to borrowers. Although banks in this model do not screen, they can monitor borrowers’ returns after the investment project is completed. The decision to monitor is made prior to making the loan (as in Diamond 1984), and monitoring is costly.21 Finally, it is assumed there are sufficient deposits for a bank to fund any number of borrowers it chooses.22 Smith shows that a competitive banking system is better than a monopoly system in that it allows for higher incomes and reduces the severity of the business cycle. Banks in general benefit the economy because their monitoring costs are lower than those incurred with bilat-  19  Figure 2  Time Line of Events for Individuals Born at Date 0 Date 0  Date 1 Borrowers obtain loans  Lenders work, obtain income, deposit with bank  Date 2  Borrowers supply capital to production process; obtain return  Borrowers undertake project and obtain return (capital)  Borrowers repay loan and consume remainder  eral lending. With a competitive system, these savings are used for additional loans, resulting in increases in production and income. When there is a monopoly bank, the savings are appropriated (by means of higher interest rates on loans) by the bank in the form of profits (and consumed by the owners). Thus, less productive investment is possible. Higher interest rates have a second detrimental impact on the economy: they raise the opportunity cost of obtaining funds for all borrowers — even those who are good risks. The intuition is that higher interest rates on loans increase the return on bank liabilities. The higher opportunity cost of funds filters through to borrowing rates in all markets for loans, regardless of the type of borrower, and this results in more firms needing to borrow to finance their projects. Finally, Smith also shows that adverse shocks to the economy are less pervasive in a system with competitive banks. Credit Rationing and Bank Structure Revisited. Like Cetorelli, and to a lesser degree Smith, Guzman (forthcoming) is interested in the impact the banking system’s market structure has on capital accumulation and economic growth. Guzman also examines how market structure affects the quantity and the likelihood of credit rationing to arise. Most of the recent theoretical literature that explores the relationship between growth and banking and includes credit rationing as a possibility considers only economies with competitive banking systems. As a practical matter though, banking systems’ industrial organization varies widely across countries. Thus, the relationship between banks and the economy is unclear when a country’s banking system is not competitive. This is the  Lenders withdraw deposits and consume  impetus for Guzman’s work. He shows that monopoly in banking tends to be detrimental to the economy because it decreases capital accumulation and growth and exacerbates the problems associated with credit rationing. As with the other two general equilibrium models, Guzman uses a variant of the Diamond (1965) overlapping-generations model with production. Two types of individuals populate the economy: lenders and borrowers. Lenders, who earn wage income when young, have two options for allocating this income: they can deposit it with a bank or use it in their own investment project.23 Borrowers have no income when young but do have investment projects, which, on average, are more productive than those of lenders. Borrowers must obtain financing to operate projects, and all borrowers are identical (ex ante) since project returns are drawn from the same random distribution (Figure 2 ). The return to a borrower’s project is private information available to anyone for a fixed cost. The basic contract between banks and borrowers is a standard debt contract. If feasible, the borrower repays principal plus interest on the loan. Otherwise, the borrower defaults on the loan and the bank verifies the borrower’s return and retains all proceeds from the investment project. Guzman shows that monopoly in banking tends to reduce capital accumulation and growth in the economy. Monopoly is also more likely to lead to credit rationing, and when rationing occurs, it tends to be more severe under a monopoly than under a competitive system.24 The intuition behind these results is best understood by looking at the differences between the interest rate charged on loans and  20  FEDERAL RESERVE BANK OF DALLAS  paid on deposits in each type of banking system. When credit rationing exists, the interest rate on loans is the same under both systems because the shortage of funds results in borrowers bidding up the price of funds to the same level. The monopoly bank pays a lower return on deposits (the source of the bank’s profits), which results in less funding being available for borrowers. This leads to a greater likelihood of credit rationing and less growth as fewer borrowers undertake productive investment projects. When credit is not rationed and all borrowers are funded, the interest rate on deposits is the same under both systems. Because the same number of borrowers is funded under either system, the same amount of funds must be deposited in the banks. The quantity of deposits depends only on the deposit interest rate, and thus the same interest rate on deposits prevails independent of the banking system. A monopoly charges a higher interest rate on loans (its source of profits). This leads to more monitoring of borrowers than with a competitive system, as the likelihood of default rises with the interest rate. Thus, a monopoly uses more resources to operate and directs fewer resources to productive investment, resulting in lower growth and capital accumulation. Finally, in some instances the monopoly bank will both charge a higher interest rate on loans and pay a lower rate on deposits. This results in more severe credit rationing, more monitoring, fewer borrowers undertaking investment projects, and ultimately less capital accumulation and economic growth. Remarks. As with the partial equilibrium models, there is a common theme with the general equilibrium models: monopoly in banking will generally be detrimental to the economy as it results in less capital accumulation and lower economic growth. This is in stark contrast to the results from the partial equilibrium models. This difference in conclusions results from the fact that the general equilibrium models take into account the detrimental effects that accrue from a monopoly bank —particularly that monopolies consume productive resources by maintaining profits at a higher level than competitive systems. However, it should be noted that one of the drawbacks to the general equilibrium models is that to be able to draw conclusions from these models, they sometimes have to sacrifice richness in terms of how individuals are modeled—especially the lack of moral hazard connected with choosing more or less risky investment projects.  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  CONCLUSION Recent events have drawn attention to the banking industry, one of the most important and vital sectors needed for an efficient market economy. It is important to understand how the various aspects of the banking system in general and the underlying structure of the banking sector in particular affect economic growth and development. Only recently have economists begun researching and better understanding the economic impact of the banking sector’s market structure. Although this article describes only a few studies, they are representative of the most recent research and allow for some general conclusions about how a monopoly bank is modeled and about bank structure’s importance to the macroeconomy. The research also suggests some possibilities for future work. One result drawn from these studies is that monopoly in banking benefits certain aspects of the economy. In particular, a monopoly bank can help overcome, or at least mitigate, some of the problems inherent in the bank – borrower relationship. As long as informational asymmetries exist and complete information is not easily and costlessly obtainable by all parties, the problems of adverse selection and moral hazard remain. A monopoly bank can partially overcome these problems by screening prospective borrowers, by using the choice of interest rates and credit rationing to induce selfselection and less risky behavior, or by relying on the development of long-term relationships. Using these techniques to address the problems related to a lack of full information is often more effectively and efficiently accomplished by a monopoly bank. However, when ascertaining the overall economic impact, it is noteworthy that partial equilibrium models find either that monopoly is beneficial or that it is unclear whether a monopoly is beneficial or detrimental. General equilibrium models find just the opposite. Either monopoly is detrimental to the economy, or, at best, the impact is ambiguous. This clearly indicates that how completely the banking sector and the economy are modeled is crucial to the results obtained. A comparison of the results of Schnitzer (a partial equilibrium model) and Cetorelli (a general equilibrium model) highlights this as both models use screening to overcome the problem of adverse selection. Both find that a monopoly bank screens more efficiently than competitive banks. However, Cetorelli also takes into account the full effects  21  ernment policy on the banking system and economy to be explicitly analyzed.  of a monopoly’s redistribution of resources away from productive purposes (that is, profits) and finds the overall impact of a monopoly is ambiguous. This suggests that to determine the macroeconomic impact of a less competitive banking system, it is important to model more than just the bank–borrower relationship. It is interesting, however, that Cetorelli does describe conditions under which monopoly would benefit the economy even under a general equilibrium framework. Cetorelli argues that the conditions under which monopoly would be beneficial are most relevant to developing countries, which are plagued by asymmetric information, problems with writing and enforcing contracts, and a lower average quality of productive capital than their developed counterparts. He indicates that these problems may be overcome, and result in greater capital accumulation, with a monopolistic banking system. This is in stark contrast to Smith and Guzman, who find that monopoly is never beneficial. This contrast indicates that even in the general equilibrium framework, more research is needed to understand under exactly what conditions and in what types of countries having a less competitive banking system might be beneficial. The research this article reviews also suggests other areas for future work. One of the major drawbacks to the existing studies is that most of them focus solely on one aspect of the bank – borrower relationship or the bank – depositor relationship. The partial equilibrium models ignore the deposit side and assume that sufficient funds can be costlessly obtained. While the general equilibrium models consider the deposit side, they do not provide a robust treatment of how banks raise the funds needed to make loans. Most of these models, with Caminal and Matutes’ the exception, allow banks the options of only screening before making the loan or only rationing credit or only monitoring after the investment project has concluded. Banks often use a number of tools to obtain information about prospective clients.25 It is also important to realize that realworld financial markets are often heavily regulated and significantly affected by government policy. For example, the stock and bond markets often react sharply to government policy announcements. Yet none of the models analyzed has scope for examining the economic impact of monetary or fiscal policy.26 Thus, it will be important to develop models that not only are better able to mimic the actual relationships between banks, borrowers, and depositors but that also allow the impact of gov-  NOTES  1  2  3  4  5  6  7  8  9  10  11  22  The author wishes to thank John Duca, Bob Moore, and Mark Wynne for their helpful comments and Monica Reeves for her careful editing. For example, although Citicorp and Travelers Group merged in 1998, without this legislation Citigroup would have been required to divest itself of the insurance underwriting business in the next couple of years. This article uses the terms banks, financial intermediaries, banking system, and financial system interchangeably. The term financial market differs from these terms in that it includes not only banks but also the stock market, insurance companies, brokers, and any other industry that provides financial capital to entrepreneurs and businesses. For a more detailed overview of the earlier literature, see Gertler (1988). Much of this section is merely a condensed version of this work. Asymmetric information occurs when not all individuals have the same information about the profitability of current or future investment projects. See, for example, Fernandez and Galetovic (1995) and De Gregorio and Guidotti (1995). They qualify King and Levine’s results by showing growth rates in developed and less developed countries differ as financial markets are established and mature. See, for instance, Atje and Jovanovic (1993), King and Levine (1993a), Demirguc-Kunt and Levine (1996), Levine and Zervos (1996), and Levine (1999). See Pagano (1993), Levine (1996), and Greenwood and Smith (1997) for an overview of some of this literature. Most of the studies this article discusses assume banks are entrepreneurs’ only source of financing. Thus, these works deal not only with monopoly in banking but, more generally, with monopoly in the financial sector. The work reviewed here is representative (but not comprehensive) of the recent theoretical literature comparing the impact of different banking structures on various aspects of the economy. Credit rationing usually takes one of two forms. Either borrowers are denied loans, or they are unable to obtain as large a loan as they would like. In most cases, credit rationing is an equilibrium outcome and not necessarily the result of market failures. When credit rationing exists, borrowers with good project returns will try to distinguish themselves from those whose projects have bad returns. This is usually accomplished through contract terms. The authors build on the ideas that Becker (1975) establishes. He examines the issue of companies providing training for employees when competitive labor  FEDERAL RESERVE BANK OF DALLAS  12  13  14  15  16  17  18  19  20  21  22  markets allow employees to sever their relationship with a firm after receiving training and before the firm can recoup its training costs. Since this article focuses on theoretical models, Petersen and Rajan’s empirical results are not discussed in detail. The empirical results are consistent with the theoretical implications of their model. The basic idea behind this statement is that banks that compete fiercely with each other often take on risky loans and investments in an effort to obtain higher profits. If these risky loans go bad (as was the case with the savings and loan failures in the 1980s), the result can be widespread failure in the banking sector. Borrowers choose more efficient (less risky) projects if the expected marginal return on the investment is sufficiently greater than the interest rate (cost of funds). The return from the project depends on the marginal productivity of capital, which is inversely related to the quantity of capital. Thus, credit rationing results in a smaller amount of capital being obtained from the bank. The smaller the amount of capital, the higher the return from the investment and the more likely the entrepreneur will choose the less risky project. See, for example, Broecker (1990), Riordan (1993), and Schnitzer (1998b) for other research examining how bank structure affects the screening process. Banks’ importance in firm financing is much greater in transition and developing economies than in developed economies because capital markets (and property rights) are usually not as well developed. See Buch (1998) for a discussion of banks’ role in transition economies. Bertrand competition occurs when firms compete only on the price they charge for a good or service. Generally, the firm with the lowest price will make all the sales. Consequently, with this type of competition firms ultimately charge the same low price. Cetorelli (1995) also examines the impact of bank structure on the macroeconomy. However, the focus of that paper is on how bank structure impacts the adoption of higher quality technology.  23  If borrowers invest in the risky project, their return is drawn from an identical random distribution. Thus, prior to operating their investment project all borrowers are identical with respect to the expected return on their project. Contracts between lenders and borrowers are assumed to be bilateral to make lenders functionally different from banks, which are merely groups of lenders pooling their resources. Economies of scale in monitoring loans give bank loans another advantage over bilateral lender contracts. Such economies are another reason only banks exist in equilibrium. Unlike the partial equilibrium models, this model’s assumption is more binding in that it constrains the level of capital stock needed for lending to be undertaken.  Bencivenga, Valerie R., and Bruce D. Smith (1991), “Financial Intermediation and Endogenous Growth,” Review of Economic Studies 58 (April): 195 – 209.  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  24  25  26  The latter option gives rise to a more robust method for understanding the restrictions the deposit side places on banks’ ability to make loans. Although banks face an upward-sloping supply of loanable funds, the link between deposits and loans is significantly weakened by the fact that borrowers’ demand for loans is modeled as being interest inelastic. Credit rationing can occur for two reasons in this model. First, it occurs if total lender income is not high enough to meet all borrowers’ demands; this can happen whether banking is competitive or monopolistic. Second, even if lender income is sufficient to meet all borrowers’ needs, loan demand may be greater than the funds banks obtain from deposits. If banks do not offer a sufficiently high interest rate on deposits, they may not entice enough lenders to deposit with the bank — resulting in a shortage of funds for borrowers. Bose and Cothren (1996) model banks as having the option to both screen and ration credit to potential borrowers. However, they do not compare the economic impact of different banking structures when banks have access to both options. Siegel (1981) is an early article that compares monetary policy’s impact on certain aspects of the economy when the banking system is competitive and when it is monopolistic.  REFERENCES Atje, Raymond, and Boyan Jovanovic (1993), “Stock Markets and Development,” European Economic Review 37 (April): 632 – 40. Bank for International Settlements (1999), “Bank Restructuring in Practice,” BIS Policy Paper no. 6. (Basel, Switzerland, August). Becker, Gary S. (1975), Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education (New York: Columbia University Press).  ——— (1993), “Some Consequences of Credit Rationing in an Endogenous Growth Model,” Journal of Economic Dynamics and Control 17 (January – March): 97–122. Bose, Niloy, and Richard Cothren (1996), “Equilibrium Loan Contracts and Endogenous Growth in the Presence of Asymmetric Information,” Journal of Monetary Economics 38 (October): 363 –76. Boyd, John H., and Edward C. Prescott (1986), “Financial Intermediary— Coalitions,” Journal of Economic Theory 38 (April): 211– 32.  23  Boyd, John H., and Bruce D. Smith (1997), “Capital Market Imperfections, International Credit Markets, and Nonconvergence,” Journal of Economic Theory 73 (April): 335 – 64.  Gale, Douglas, and Martin Hellwig (1985), “IncentiveCompatible Debt Contracts,” Review of Economic Studies 52 (October): 647– 63. Gertler, Mark (1988), “Financial Structure and Aggregate Economic Activity: An Overview,” Journal of Money, Credit, and Banking 20 (August, pt. 2): 559 – 88.  ——— (1998), “Capital Market Imperfections in a Monetary Growth Model,” Economic Theory 11 (March): 241–73. Broecker, Thorsten (1990), “Credit-Worthiness Tests and Interbank Competition,” Econometrica 58 (March): 429 – 52.  Goldsmith, Raymond W. (1969), Financial Structure and Economic Development (New Haven: Yale University Press).  Buch, Claudia M. (1998), “Towards Universal Banking: Risks and Benefits for Transition Economics,” in Competition and Convergence in Financial Markets: The German and Anglo-American Models, eds. Stanley W. Black and Mathias Moersch (New York: Elsevier), 333 – 68.  Greenwood, Jeremy, and Boyan Jovanovic (1990), “Financial Development, Growth, and the Distribution of Income,” Journal of Political Economy 98 (October, pt. 1): 1076 –1107.  Cameron, Rondo (1967), Banking in the Early Stages of Industrialization (New York: Oxford University Press).  Greenwood, Jeremy, and Bruce D. Smith (1997), “Financial Markets in Development and the Development of Financial Markets,” Journal of Economic Dynamics and Control 21 (January): 145 – 81.  Caminal, Ramón, and Carmen Matutes (1997), “Bank Solvency, Market Structure, and Monitoring Incentives,” Centre for Economic Policy Research Discussion Paper no. 1665 (London, June).  Guzman, Mark G. (forthcoming), “Bank Structure, Capital Accumulation, and Growth: A Simple Macroeconomic Model,” Economic Theory.  Cetorelli, Nicola (1995), “The Role of Credit Market Competition in Promoting Technological Progress” (Brown University, December, Photocopy).  King, Robert G., and Ross Levine (1993a), “Finance, Entrepreneurship, and Growth: Theory and Evidence,” Journal of Monetary Economics 32 (December): 513 – 42.  ——— (1997), “The Role of Credit Market Competition on Lending Strategies and on Capital Accumulation,” Federal Reserve Bank of Chicago Working Paper no. 97-14 (Chicago, December).  ——— (1993b), “Finance and Growth: Schumpeter Might Be Right,” Quarterly Journal of Economics 108 (August): 717– 37.  De Gregorio, Jose, and Pablo Guidotti (1995), “Financial Development and Economic Growth,” in Road Maps to Prosperity: Essays on Growth and Development, ed. Andrés Solimano (Ann Arbor: University of Michigan Press), 237– 66.  Krasa, Stefan, and Anne P. Villamil (1992), “The Theory of Optimal Bank Size,” Oxford Economic Papers 44 (October): 725 – 49. Levine, Ross (1996), “Financial Development and Economic Growth: Views and Agenda,” World Bank Policy Research Working Paper no. 1678 (Washington, D.C., October).  Demirguc-Kunt, Asli, and Ross Levine (1996), “Stock Market Development and Financial Intermediaries: Stylized Facts,” World Bank Economic Review 10 (May): 291– 321.  ——— (1999), “Law, Finance, and Economic Growth,” Journal of Financial Intermediation 8 (January–April): 8–35.  Diamond, Douglas W. (1984), “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies 51 (July): 393 – 414.  Levine, Ross, and Sara Zervos (1996), “Stock Market Development and Long-Run Growth,” World Bank Economic Review 10 (May): 323 – 39.  Diamond, Peter A. (1965), “National Debt in a Neoclassical Growth Model,” American Economic Review 55 (December): 1126 – 50.  McKinnon, Ronald I. (1973), Money and Capital in Economic Development (Washington, D.C.: Brookings Institution).  Fernandez, David, and Alexander Galetovic (1995), “Schumpeter Might Be Right — But Why? Explaining the Relationship between Finance, Development, and Growth,” Johns Hopkins University SAIS Working Paper in International Economics no. 96-01 (Washington, D.C., January).  Pagano, Marco (1993), “Financial Markets and Growth, An Overview,” European Economic Review 37 (April): 613 – 22.  24  FEDERAL RESERVE BANK OF DALLAS  Petersen, Mitchell A., and Raghuram G. Rajan (1995), “The Effect of Credit Market Competition on Lending Relationships,” Quarterly Journal of Economics 110 (May): 407– 44.  Smith, R. Todd (1998), “Banking Competition and Macroeconomic Performance,” Journal of Money, Credit, and Banking 30 (November): 793 – 815. Stiglitz, Joseph E., and Andrew Weiss (1981), “Credit Rationing in Markets with Imperfect Information,” American Economic Review 71 (June): 393 – 410.  Riordan, Michael H. (1993), “Competition and Bank Performance: A Theoretical Perspective,” in Capital Markets and Financial Intermediation, eds. Colin Mayer and Xavier Vives (New York: Cambridge University Press), 328 – 43.  Townsend, Robert M. (1979), “Optimal Contracts and Competitive Markets with Costly State Verification,” Journal of Economic Theory 21 (October): 265 – 93.  Schnitzer, Monika (1998a), “On the Role of Bank Competition for Corporate Finance and Corporate Control in Transition Economies,” Centre for Economic Policy Research Discussion Paper no. 2013 (London, November).  Williamson, Stephen D. (1986), “Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing,” Journal of Monetary Economics 18 (September): 159 –79.  ——— (1998b), “Bank Competition and Enterprise Restructuring in Transition Economies,” Centre for Economic Policy Research Discussion Paper no. 2045 (London, December).  ——— (1987), “Costly Monitoring, Loan Contracts, and Equilibrium Credit Rationing,” Quarterly Journal of Economics 102 (February): 135 – 45. Winton, Andrew (1995), “Delegated Monitoring and Bank Structure in a Finite Economy,” Journal of Financial Intermediation 4 (April): 158 – 87.  Shaw, Edward S. (1973), Financial Deepening in Economic Development (New York: Oxford University Press). Siegel, Jeremy J. (1981), “Inflation, Bank Profits, and Government Seigniorage,” American Economic Review 71 (May): 352 – 55.  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  25  It has become fashionable in some economic circles to suggest that the unemployment rate in America is too low. Reductions routinely trigger stock market declines and are accompanied by baleful warnings that low levels of unemployment are unsustainable. This line of reasoning views low unemployment as the byproduct of an overheated American economic engine whose long-run effects will inevitably hurt the United States through both inflation and a resurgence of unemployment.1 The U.S. unemployment rate fell to a thirty-year low of 3.9 percent in April 2000 — more than two percentage points below the 6 percent that was widely regarded as unsustainable during the 1980s. Moreover, the unemployment rate has remained at supposedly unsustainable levels for each of the past five years, which suggests the remarkable unemployment performance of the American economy cannot be explained solely by short-term overheating. Explanations given in previous work include unusually strong productivity gains, increased global competition, and more skillful businesscycle management by government.2 This article discusses two other factors that have contributed to the low rate of unemployment in America today: welfare reform and technological advancement. Yet these factors are not without controversy. Welfare reform opponents argue that welfare recipients face such formidable problems in their everyday lives that they simply cannot work, with or without a social safety net. On the technology side, interest groups wary of technological change envision a “digital divide” that dooms low-skilled Americans to unemployment while high-skilled Americans prosper.3 It may well be the case that some welfare recipients cannot work, especially those who struggle with physical ailments or addictions to alcohol or drugs. It may also be the case that the ongoing technological revolution will provide disproportionate benefits to those who are intimately familiar with computers. But is there reason to believe at least some welfare recipients are finding work following the American welfare reform law of 1996? Also, is there reason to believe low-skilled and disabled workers are reaping benefits from technological change along with high-skilled workers? In this article, I examine these questions. First, I present a job-search model that provides a theoretical framework for analyzing the impact welfare reform and technological change have on unemployment. I discuss the empirical evidence surrounding welfare reform and present a model consistent with that evidence. I then  The Effect of Welfare Reform and Technological Change on Unemployment Jason L. Saving  T  his article examines the  concept of unemployment and, using a model derived from the job-search literature, explores how welfare reform and technological change affect it.  Jason L. Saving is an economist in the Research Department at the Federal Reserve Bank of Dallas.  26  FEDERAL RESERVE BANK OF DALLAS  wage, w *, above which the individual will agree to work but below which the individual will continue to search for a job. Note that this reservation wage is independent of the number of previously rejected offers. An individual who receives an offer after one hundred periods will react identically to an individual who receives the same offer after one period. If the offer is high enough, it is accepted; if not, it is rejected. Before turning to specific policy issues, it is useful to examine how the reservation wage changes as the cost associated with rejecting a job offer changes. From Equation 3, the reservation wage is a function of three things: a time discount rate, the job-search cost, and the utility an individual could expect to obtain by turning down an initial job offer. Differentiating Equation 3 with respect to c yields  analyze the controversial claim that welfare reform can cause unemployment, and I find that seemingly minor changes in how unemployment is measured can produce dramatic differences in its level. Finally, I discuss the extent to which technological change is helping lowskilled or disabled Americans, and I provide a model consistent with that evidence. The article draws three main conclusions. First, welfare reform can reduce unemployment, and the empirical evidence to date suggests the recent American welfare reform effort has caused hundreds of thousands of Americans to leave the welfare rolls and enter the labor force. Second, welfare reform can increase the official unemployment rate by drawing new people into the pool of job seekers, but it cannot increase the number of people who are out of work. Finally, technological change can help low-skilled or disabled individuals become productive members of the labor force, and there is reason to believe it has done so during the 1990s.  (4)  From Equation 4, the direction in which the reservation wage changes is based on the discount rate and the change in turn-down utility, dV 0/dc. By definition, 0 < β < 1. Moreover, dV 0/dc must be less than zero because higher search costs provide (other things equal) a greater incentive for job seekers to accept the best offer they are given in a current period rather than forgoing that offer and paying additional search costs in the future. Therefore, higher search costs unambiguously reduce an individual’s reservation wage. In other words, individuals whose search costs rise will settle for a lower wage than they would have insisted upon if their job-search costs were lower. Suppose the world changes in such a way that individuals are able to receive a greater number of job offers in any given period. Before this change occurs, an individual receives N job offers from distribution r and has to choose whether to accept or reject the highest offer. Assuming the additional job offers are drawn from r, the expected best offer in any period must rise because more offers are received. More formally, the new best-offer function, fN , stochastically dominates the best-offer function that existed previously.7 From Equation 2, the utility V 0 of rejecting any given wage is determined by an integration with respect to the function f. Since f is stochastically dominated by fN , such an integral must be larger with fN than with f, which implies V 0 is unambiguously larger under fN . From Equation 3, the reservation wage is also larger under fN , so the individual will demand a higher wage before accepting an offer if more offers per period are received.  A JOB-SEARCH MODEL To better understand the relationship between employment and public policy, it is helpful to consider a model in which individuals receive a fixed number of job offers each period and must decide whether to accept or reject the best offer (Stokey and Lucas 1989).4 Suppose that an infinitely lived job seeker receives, in each period, a best wage offer w drawn from distribution f (w), which itself is derived by receiving N offers from distribution r.5 The individual has two options: accepting the offer (and ending the job search) or rejecting it and receiving another offer the following period. If the person accepts, lifetime utility is (1)  U (w) = Σβtw = w/(1 – β),  where β denotes the individual’s discount rate and t is an index variable that measures time. If the offer is rejected, the individual suffers a (monetized) penalty, c, from the job-search process and repeats the search process in the next period.6 In this case, lifetime utility is (2)  U (~w) = –c + V (s)df (s) = –c + V 0,  where V (s) represents lifetime expected utility and s represents the individual’s next-period best offer (which need not be accepted). Under these assumptions, the individual will choose to accept offer w when and only when (3)  w > (1 – β)(–c + V 0 ).  That is to say, there is a unique reservation  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  dw */dc = (1 – β)(–1 + dV 0/dc).  27  which is unambiguously higher than the quantity in Equation 2. And under these assumptions, the individual will accept an offer only when  This model permits an examination of the employment-related aspects of welfare reform and technological change.  (7) WELFARE REFORM  The wage at which an individual will work is unambiguously higher in Equation 7 than in Equation 3, which suggests two things. First, welfare benefits cause individuals to spend more time searching for a high-wage job than they otherwise would because the costs of that search are partially borne by the taxpayer. Second, welfare benefits cause employment to be lower than it would otherwise be because individuals spend more time searching for work and less time working. By introducing time limits and work requirements, the 1996 welfare reform legislation in effect reduced the welfare benefit level. In the model given here, welfare reform accomplishes the stated goal of its proponents: the individual is more likely to accept work in any given period, which reduces unemployment.10  The United States has had a governmentrun social safety net for more than sixty years to provide aid to needy citizens.8 The system began in 1936, when President Franklin Roosevelt responded to the Great Depression by implementing the set of federal policies commonly known as the New Deal. The federal social safety net expanded during the 1960s Great Society to the point that over one hundred welfare programs were available to the needy (Dobelstein 1986).9 As the system became more generous and more expansive, the number of families receiving welfare benefits grew. Between 1966 and 1972, welfare recipiency increased from 1.09 million families to 3.05 million families. The figure then rose as high as 5 million families in 1994, the year in which the first draft of the welfare reform law was unveiled to the American public. Believing the system discouraged work, President Clinton signed legislation in 1996 that dramatically reformed welfare. The law, known as the Personal Responsibility and Work Opportunity Reconciliation Act, limits the number of months individuals can receive checks. The law also requires recipients (with some exceptions) to perform some sort of work-related service, though this service does not have to take the form of a private-sector job.  The Evidence The social science literature of the last twenty years provides a moderate amount of support for the hypothesis that welfare benefit levels affect welfare recipiency. Previous work has found links between generosity and recipiency in a wide variety of government programs, including Aid to Families with Dependent Children (AFDC) (Robins 1986), AFDC-Unemployed Fathers Program (Hosek 1980), Medicaid (Blank 1989), and food stamps (Fraker and Moffitt 1988). More recent work (Shroder 1995, Peterson and Rom 1990) indicates this link may not be as strong as had been previously thought. However, the relatively broad scope of the welfare reform law and the relatively narrow year-toyear changes with which most of these studies are concerned suggest that previous work may not be a good guide to the success or failure of the current welfare reform effort. Instead, given the relatively recent passage of the welfare reform law and the degree to which that law changed the system, perhaps the best way to determine whether it has affected welfare recipiency is to look beyond past studies and examine present empirical evidence. The evidence to date indicates welfare reform has significantly affected welfare recipiency and that a large number of displaced welfare recipients have responded by moving into the labor market. Recipiency is down in every state (Table 1 ), and the average decline in the United States as a whole is over 40 percent. The  Modeling Welfare Reform Welfare programs are designed to make unemployment more bearable. This has many laudable effects, but it necessarily tilts the individual decision-making calculus away from work and toward welfare. In simplest terms, some people will choose not to work if the choice provides tangible benefits. To capture the effects of a change in welfare policy using the job-search framework presented above, suppose the government institutes a cash welfare benefit, b, that is paid only to individuals who do not work. Lifetime utility associated with accepting an offer in this case remains (5)  U (w) = βtw = w/(1 – β),  but the lifetime utility associated with rejecting an offer becomes (6)  w > (1 – β)(b – c + V 0 ).  U (~w) = b – c + V (s)df (s) = b – c + V 0,  28  FEDERAL RESERVE BANK OF DALLAS  Table 1  Number of Welfare Recipients Declines August 1996 Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware District of Columbia Florida Georgia Guam Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Puerto Rico Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virgin Islands Virginia Washington West Virginia Wisconsin Wyoming U.S. Total  September 1999  Percent change  100,662 35,544 169,442 56,343 2,581,948 95,788 159,246 23,654 69,292 533,801 330,302 8,314 66,482 21,780 642,644 142,604 86,146 63,783 172,193 228,115 53,873 194,127 226,030 502,354 169,744 123,828 222,820 29,130 38,592 34,261 22,937 275,637 99,661 1,143,962 267,326 13,146 549,312 96,201 78,419 531,059 151,023 56,560 114,273 15,896 254,818 649,018 39,073 24,331 4,898 152,845 268,927 89,039 148,888 11,398  46,086 22,546 88,485 29,707 1,668,173 32,507 79,071 15,515 48,576 174,588 140,558 9,497 42,713 2,222 321,999 111,842 56,302 32,199 92,415 86,470 33,474 76,504 121,586 234,262 116,623 33,911 124,519 13,191 29,378 17,032 14,677 152,535 76,300 763,648 108,179 8,064 247,798 39,200 43,204 269,515 99,022 47,942 39,847 6,932 149,005 287,296 23,427 17,403 3,387 86,279 160,471 32,238 23,892 1,395  – 54 – 37 – 48 – 47 – 35 – 66 – 50 – 34 – 30 – 67 – 57 14 – 36 – 90 – 50 – 22 – 35 – 50 – 46 – 62 – 38 – 61 – 46 – 53 – 31 – 73 – 44 – 55 – 24 – 50 – 36 – 45 – 23 – 33 – 60 – 39 – 55 – 59 – 45 – 49 – 34 – 15 – 65 – 56 – 42 – 56 – 40 – 28 – 31 – 44 – 40 – 64 – 84 – 88  12,241,489  6,603,607  – 46  SOURCE: U.S. Department of Health and Human Services.  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  29  Figure 1  To examine the effect of welfare reform on unemployment, it is important to understand the relationship between unemployment and labor force participation. The federal government defines the employment rate as the number of workers divided by the number of people who wish to work. The labor force participation rate, in contrast, is the number of workers divided by the size of the working-age population. While conceptually similar, these definitions differ in the way they treat people who are unemployed and do not seek work either because they are discouraged or because they prefer to receive welfare benefits. These differences have important implications for the unemployment rate. As long as most people are either working or searching for work, the employment and labor force participation rates will not differ substantially. When a significant number of people cease searching for work, however, the difference can be considerable. For example, suppose that every American but one decided to permanently exit the labor force. The employment rate would be 100 percent if that one individual had a job and zero percent if that one individual did not. However, the labor force participation rate would be negligible in either case because no more than one person would be working. Figure 1 shows the U.S. unemployment rate and the percentage of the population neither working nor seeking work. As can be seen, there is little correlation between these two measures of joblessness. It is therefore important to consider labor force participation. Integrating labor force participation into the job-search framework outlined above permits a more comprehensive examination of welfare reform. For expositional simplicity and to demonstrate the robustness of the result, I make two assumptions that exaggerate the effectiveness of welfare reform and then examine the period immediately after its implementation. First, consistent with a recent study that suggests welfare benefits are considerably more generous than is typically thought (Tanner, Moore, and Hartman 1995), suppose no recipient in the prereform world searched for work.11 Second, consistent with the intent of welfare reform, suppose every recipient in the postreform world searches for work. Even in this extreme example, welfare reform cannot be expected to eliminate recipiency because those who do not accept their best-wage offer in any given period still receive benefits. Calculating w * from Equation 7, a proportion of former recipients, F (w *), will be  Percentage of Labor Force Unemployed and Population Not in Labor Force Percent  Percent  12  45  11 40 10  Population not in labor force  35  9 8  30  7 25 6 Labor force unemployed  20  5 4  15 ’80  ’82  ’84  ’86  ’88  ’90  ’92  ’94  ’96  ’98  ’00*  * 2000 data are calculated by averaging the values for January–May. SOURCE: Bureau of Labor Statistics.  drops are most dramatic in states in which welfare reform efforts have been greatest, with declines of more than 80 percent in Wisconsin (which pioneered welfare reform at the state level) but less than half this amount in Hawaii and the District of Columbia, which have done little (beyond the requirements of the welfare reform law) to change their welfare systems. Moreover, a recent study by the General Accounting Office (1999) finds that a majority of these individuals left welfare for work and continue to work today. In summary, there is strong empirical evidence that welfare reform has encouraged work. It should be noted that moving people into the labor force is not the welfare system’s only purpose. So the fact that welfare reform has facilitated such movement does not address the issue of whether welfare reform is desirable. At a minimum, however, the evidence demonstrates that welfare reform has affected the behavior of welfare recipients. LABOR FORCE PARTICIPATION One of the most important reasons welfare reform was signed into law was its expected effect on employment. Passage of the bill, claimed proponents, would cause a substantial rise in employment and ever-lower levels of unemployment. In this section, I show that welfare reform need not decrease the unemployment rate and may actually raise it. However, welfare reform will increase the number of workers because of its impact on labor force participation.  30  FEDERAL RESERVE BANK OF DALLAS  offered a wage less than w * and decline to work, while 1 – F (w *) will be offered a wage greater than w * and will accept a job. If the number of prereform workers is Q, the number of prereform recipients is R, and the number of prereform nonrecipients seeking work is S, the change in the labor force participation rate is (8)  downward effect on unemployment in the United States. TECHNOLOGICAL ADVANCES Technological advancement has been a defining feature of the modern industrial economy. While such advancement is often portrayed as a process in which tech-savvy individuals prosper while low-skilled people are left behind in a “digital divide,” some innovations provide disproportionate benefits to low-skilled people and others help everyone. This section discusses the effects of each of these types of technological advances on workers.  ∆L = (R)[1 – F (w *)] > 0,  the change in the number of employees is (9)  ∆E = (R + S )[1 – F (w *)] > 0,  and the change in the unemployment rate is (10)  ∆U = [(QS )F (w *) – (QR + R 2 + RS ) (1 – F (w *))] ÷ [(Q + R)(Q + R + S )].  Low-Skilled Workers As the current economic expansion continues, a growing number of people previously considered unemployable (such as those who cannot add or cannot read) have entered the U.S. labor force.12 Technological advancements have played a key role in helping people overcome their disadvantages. Those who lack strength or mobility can use machines to lift objects or move from one location to another. Those who lack dexterity can operate machines that perform manual labor. Even people who cannot read can perform tasks by touching pictures on a computer screen rather than typing. There are many other examples of how technology has helped reduce the need for physical skills, and in each case, people who previously lacked the requisite qualifications to work became employable. But why is anyone “unemployable” in a market economy where employers base pay on a worker’s contribution to company output? The answer is found in the minimum wage. It is often argued that the minimum wage raises wages for everyone who works, and there is evidence to suggest this is true for people who can produce at a level equal to or greater than the minimum wage. However, people who, for whatever reason, find it difficult to produce at that level will also find it difficult to find or retain a job because hiring them at the minimum wage may be unprofitable for an employer. In an age of heightened sensitivity toward the less fortunate and the disabled, it is especially important to examine this issue and find ways these individuals can use their talents to benefit both themselves and society. Returning to the job-search model of the previous section, suppose a subset of individuals lacks the skills or abilities needed to perform certain jobs.13 These differences can be reflected  These equations reveal two interesting aspects of welfare reform. First, Equations 8 and 9 show that reform necessarily increases the size of the labor force and raises the number of workers in the economy. Second, however, Equation 10 demonstrates that the unemployment rate will not necessarily fall because the increased number of workers is accompanied by an increased number of people who seek work but do not immediately find it. From Equation 10, the extent to which the unemployment rate rises or falls after welfare reform is determined primarily by the extent to which former welfare recipients’ work behavior mirrors that of the population at large. If the proportion of former welfare recipients who find work is relatively high, welfare reform will cause the unemployment rate to fall. If the proportion is relatively low, welfare reform will cause the unemployment rate to rise. In all cases, however, welfare reform causes more people to work—it is simply the standard unemploymentrate definition whose sign is uncertain. Given the popularity of the standard unemployment rate as a measure of economic health, can anything be said about whether, as an empirical matter, welfare reform is likely to raise or lower the unemployment rate? According to the best available data, approximately two-thirds of those leaving the welfare rolls in response to American welfare reform found jobs and were still working a year later (General Accounting Office 1999), which is almost equal to the labor force participation rate of the population as a whole. Moreover, the demographic characteristics of former welfare recipients — primarily single female heads of household— would generally be associated with lower labor force participation rates. While it is too early to draw any firm conclusions, it seems reasonable to infer that welfare reform has exerted a modest  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  31  Now, suppose a technological advancement occurs that complements existing skills, thus widening the disparity between the bestoffer distributions for low- and high-skilled workers in much the same way that technological change in the previous subsection lessened the disparity. Because the minimum wage is not binding for high-skilled workers, it is impossible to say whether the combination of higher demand from employers and higher salary demands from high-skilled people would increase or decrease the number of high-skilled workers. However, it does have one important real-world implication: the income distribution would be increasingly unequal, which suggests that technological advancement can exacerbate as well as mitigate the digital divide. The extent to which technological advancement increases the disparity between rich and poor has been a matter of considerable debate in recent years. While a full treatment of this issue is beyond the scope of this article, it should be noted that many aspects of the American economy increase income inequality yet are regarded as socially desirable. For example, recent gains in the number of collegeeducated Americans have “worsened” the distribution of income as the newly educated pull farther away from those at the bottom of the income ladder, yet no one is advocating that people be discouraged from attending college. Moreover, while conventional wisdom paints an admittedly depressing picture of eternal havenots forgotten by the rest of society, low-income individuals show a remarkable ability to better themselves and move up the income distribution into the middle class and even the upper class (Cox and Alm 1995).  either by a reduction in the number of offers, N, received in any given period relative to an ordinary worker or by a shift in the offer distribution, r, that reduces the average amount of money offered relative to an ordinary worker. In either case, the best-offer function, fD , for these individuals is stochastically dominated by the standard best-offer distribution, f. From Equation 3, the reservation wage for these individuals will be lower than that for ordinary workers. Importantly, lower skilled and disabled individuals will suffer disproportionately from any minimum wage wM —that is, they will have a higher probability of unemployment in any given period —because they are less likely to receive an offer above it. Now, suppose technological change increases the proportion of jobs these individuals can perform. This change boosts the number of offers they receive in any given period, which in turn shifts their best-offer function, fD , toward the best-offer function, f, for other workers. As a result, the probability that a low-skilled or disabled person will receive a best offer, w, greater than the minimum wage, wM , in any given period rises. To the extent that this model captures the essential features of technological advances, such advances can be expected to increase labor force participation by low-skilled and disabled individuals. In a very real sense — as Federal Reserve Chairman Alan Greenspan and others have said—firms are now able to “employ the unemployable.” High-Skilled Workers The job-search model can also be used to examine ways in which technological change can benefit high-skilled individuals. Despite increasing attempts to make computer hardware and software user-friendly, many technological advances simply cannot be readily understood or utilized by those with insufficient skills. Suppose individuals differ only with respect to a productivity attribute, pi , normally distributed across the population. If firms adjust their wage offerings based on the productivity of potential hires, individuals with higher productivity should have a relatively favorable wage distribution from which to draw. To model this in the job-search framework, let the best-offer function be conditioned on worker productivity, so that it becomes f (w;pi ). Then the reservation wage equation becomes (11)  Search Costs In at least one respect, workers of all skill levels have benefited from the computer revolution: the technology-driven evolution of the job-search process. Until the latter part of the twentieth century, job hunting was often cumbersome and time-consuming. Those in search of work often traveled from city to city or spent days in libraries poring over copies of major newspapers. Finding work could take months or even years. With the Internet, however, the job-search process has become much faster for workers and companies alike. It has been estimated that several million resumes are now online and available to employers across the nation. And with the Internet now available to about half the U.S. population, job seekers can sort through  wi > (1 – β)(–c + Vi 0 ).  By Equation 11, reservation wages will be an increasing function of productivity.  32  FEDERAL RESERVE BANK OF DALLAS  job listings from across the country in a matter of seconds. Clearly, the job-search process has been revolutionized by the technological advances of the 1990s. As with the technological advancement model given at the beginning of this section, the Internet can be modeled as an expansion of the number of job offers an individual can consider in any given period. This expansion shifts the best-offer function f in a direction beneficial to the worker. Thus, every potential worker—not just those on the favorable end of the so-called digital divide and not just those whose skills or abilities once rendered them unemployable — can benefit from technological change.  NOTES 1  2  3  4  5  6  CONCLUSION  7  Unemployment is one of the most closely watched measures of economic health in America. Strong opinions exist regarding both its desirability and its inevitability, with high unemployment cursed for the misery it inflicts on the unemployed but low unemployment feared as an omen of an overheated economy. This article examines the concept of unemployment and, using a model derived from the job-search literature, explores how welfare reform and technological change affect it. The article presents several findings. First, unemployment is inevitable in a market economy, but not everyone who is unemployed is so because of historical inevitability. Second, welfare reform and technological advances can boost employment, with a potentially disproportionate impact on groups such as the low-skilled and the disabled. Finally, when a large number of individuals begin to look for work due to factors such as welfare reform, the unemployment rate need not fall but the number of workers in the economy will certainly rise. In the real world, it can be difficult to determine why people do not work. Even so, changes to government policy or the broader economy can mitigate unemployment. Laws such as welfare reform can encourage people previously outside the labor force to enter it. Technological change can speed the job-search process and make it possible for those with low skills or disabilities to work as efficiently as other workers. To the extent that current unemployment figures are driven by the removal of governmental and technological inhibitions on work rather than by an overheated economy, the remarkably low unemployment rate in America today should be cause for celebration rather than trepidation.  ECONOMIC AND FINANCIAL REVIEW SECOND QUARTER 2000  8  9  10  11  12  13  See Kudlow (1998) and Herbert (1997) for commentary on this issue. See Koenig (1998) for a discussion of these and other factors. A recent study from the U.S. Department of Commerce (1999) discusses the digital divide and some of its implications. Other work in the job-search literature includes Mortensen and Pissarides (1994) and Pissarides (1994). In this framework, the wage includes the monetized values of all amenities or other job differences, so that an individual always prefers a higher wage job to a lower wage job. See Saving (1998) for a discussion of factors that affect this cost. Stochastic dominance is discussed further in Rothschild and Stiglitz (1970) and Hadar and Russell (1969). Katz (1986) has an enlightening history of public and private welfare provision in the United States. For a more critical look at this history, see Olasky (1992). Other forms of welfare, such as food stamps and Medicaid, were in-kind programs whose eligibility requirements were less strict. The model given here does not consider the welfare system’s effect on taxation. If a balanced-budget assumption were made, reductions in welfare benefits would also raise after-tax wages and thereby make welfare reform considerably more effective than is the case in the model given here. In the real world, a significant but unknown number of recipients work but do not report their income to the Internal Revenue Service. Though disabled individuals received relatively little attention in the past, at least one in eight members of the U.S. population is officially categorized as disabled (U.S. Census Bureau 1998). Of course, many things commonly thought of as disabilities have no impact on worker productivity. For the purposes of this section, individuals with these types of disabilities are not considered disabled.  REFERENCES Blank, Rebecca (1989), “The Effect of Medical Need and Medicaid on AFDC Participation,” Journal of Human Resources 24 (Winter): 54 – 87. Cox, W. Michael, and Richard Alm (1995), “By Our Own Bootstraps: Economic Opportunity and the Dynamics of Income Distribution,” Federal Reserve Bank of Dallas 1995 Annual Report. Dobelstein, Andrew W. (1986), Politics, Economics, and Public Welfare (Englewood Cliffs, N.J.: Prentice Hall).  33  Fraker, Thomas, and Robert Moffitt (1988), “The Effect of Food Stamps on Labor Supply: A Bivariate Selection Model,” Journal of Public Economics 35 (February): 25 – 56.  Pissarides, Christopher A. (1994), “Search Unemployment with On-the-Job Search,” Review of Economic Studies 61 (July): 457–75.  General Accounting Office (1999), Welfare Reform: Information on Former Recipients’ Status, GAO/HEHS Report no. 99-48 (Washington, D.C.: U.S. Government Printing Office).  Robins, Philip (1986), “Child Support, Welfare Dependency, and Poverty,” American Economic Review 76 (September): 768 – 88. Rothschild, Michael, and Joseph E. Stiglitz (1970), “Increasing Risk: I. A Definition,” Journal of Economic Theory 2 (September): 225 – 43.  Hadar, Josef, and William R. Russell (1969), “Rules for Ordering Uncertain Prospects,” American Economic Review 59 (March): 25 – 34.  Saving, Jason L. (1998), “Is Unemployment Too Low?” Federal Reserve Bank of Dallas Southwest Economy, Issue 6, November/December, 5 – 8.  Herbert, Bob (1997), “Bogeyman Economics,” New York Times, April 4, A35. Hosek, James R. (1980), “Determinants of Family Participation in the AFDC-Unemployed Fathers Program,” Review of Economics and Statistics 62 (August): 466 –70.  Shroder, Mark (1995), “Games the States Don’t Play: Welfare Benefits and the Theory of Fiscal Federalism,” Review of Economics and Statistics 77 (February): 183 – 91.  Katz, Michael B. (1986), In the Shadow of the Poorhouse: A Social History of Welfare in America (New York: Basic Books).  Stokey, Nancy L., and Robert E. Lucas (1989), Recursive Methods in Economic Dynamics (Cambridge: Harvard University Press).  Koenig, Evan (1998), “What’s New About the New Economy? Some Lessons from the Current Expansion,” Federal Reserve Bank of Dallas Southwest Economy, Issue 4, July/August, 7–11.  Tanner, Michael, Stephen Moore, and David Hartman (1995), “The Work vs. Welfare Trade-Off,” CATO Institute Policy Analysis no. 240.  Kudlow, Lawrence (1998), “Why the Saber-Rattling?” Washington Times, May 14, A20.  U.S. Census Bureau (1998), Statistical Abstract of the United States (Washington, D.C.: U.S. Government Printing Office).  Mortensen, Dale T., and Christopher A. Pissarides (1994), “Job Creation and Job Destruction in the Theory of Unemployment,” Review of Economic Studies 61 (July): 397– 415.  U.S. Department of Commerce (1999), “Falling Through the Net: Defining the Digital Divide” (Washington, D.C.: U.S. Government Printing Office).  Olasky, Marvin (1992), The Tragedy of American Compassion (Washington, D.C.: Regnery Publishing). Peterson, Paul E., and Mark C. Rom (1990), Welfare Magnets: A New Case for a National Standard (Washington, D.C.: Brookings Institution).  34  FEDERAL RESERVE BANK OF DALLAS