39th Annual Federal Reserve Bank of St. Louis Fall Conference

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Economist Interviews from the 39th AnnualFederal Reserve Bank of St. Louis Fall Conference

Oct. 9-10, 2014

CONNECTING POLICY WITH FRONTIER RESEARCH

2014


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At the Federal Reserve Bank of St. Louis, we have long tried

to provide perspectives on whether the policies adopted inthe past still serve us well today and whether recent develop-ments at the frontier of research can be fruitfully applied toimprove policy. Tis agenda has become especially import-ant in the past few years, as the Federal Reserve and centralbanks around the world have struggled to devise appropriatepolicy responses to the current macroeconomic situation.

In polite economist society, there has long been a distinctionbetween what is known as frontier research and what issometimes called policy research. In my view, this hasbeen and continues to be a false dichotomy. Tere is no suchdistinction: Policy and frontier research are two sides ofthe same coin. We need to understand both how fundamen-tal mechanisms in the economy operate as well as how cur-rent data can be interpreted in terms of fundamental theory.

In short, advanced economic theory has to be made morerelevant for actual policy, and actual policy has to under-stand and embrace the sometimes difficult ideas advancedin the theoretical world. Te St. Louis Fed has long been aleader in supporting research at the intersection of economictheory and economic policy.

At our 2014 fall conference, we were fortunate to have an

outstanding group of speakers whose research expands ourunderstanding of key contemporary issues in macroeconom-ics. Te conference agenda included papers on labor marketsand education, banking regulation issues, and other topics.Te St. Louis Fed was proud to provide this forum for dis-cussion and analysis of the leading issues of the day.

In addition to finding ways to connect the research worldwith the policy world, the St. Louis Fed strives to connectacademic research with a nonacademic audience. Our goal isto explain in lay terms why the research is important, whatimplications it has for policy and what it means for peopleand the economy overall.

Tis volume brings the main findings of the research pre-sented during the conference to a wider audience. We hopethat you find the material informative and that it will serveas a resource on important macroeconomic and policy issues.

James BullardPresident and CEO

Federal Reserve Bank of St. Louis

MESSAGE FROM

THE PRESIDENT


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Te Research division of the Federal Reserve Bank of St.

Louis has long been renowned for its cutting-edge research,policy analysis and provision of economic information to thepublic. Tis tradition dates back to the 1960s, when Homer

Jones was the director of the Banks Research division. Atthat time, the St. Louis Fed took a very contrarian stance onhow monetary policy should be conducted and backed thatstance with top-flight economic research.

We have found that the best policy advice comes fromeconomists who work at the frontier of economic think-ing. Academic economists are often vocal in their viewsabout policy and are willing to critique actions taken by theFederal Open Market Committee, the main policymakingbody of the Federal Reserve System. o evaluate argumentsof academic critics and make use of good ideas and researchfor policy, the Fed must have economists who work at thefrontier of knowledge. Fed economists must be able toexplain their own views in a rigorous way, as well as explain

why an alternative claim about policy is suspect. A healthycompetition of ideas allows the best theories and policies to

win in the end.

MESSAGE FROM

THE RESE ARCH DIRECTOR

Academic research is valuable because the thinking about

economic issues is unrestricted. It is proactive in that it oftenfocuses on interesting issues long before they come to theattention of policymakers.

Academic research is rigorously vetted before publication inpeer-reviewed journals. It is forged in the fires of debate andcriticism. Academic research also takes the form of programevaluation (economic autopsies) of major economic events.It can take years to analyze and understand what happenedand what policies or regulations need to be changed.

At the St. Louis Fed, we continually look for ways to connectfrontier research with policy. Our annual fall conference,

which brings together leading academics and economists,does just that. Te discussions that follow highlight someof the key contributions of the papers presented at the 2014fall conference.

Christopher J. WallerSenior Vice President and Research Director



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Every year, two economists from the Research division of the

Federal Reserve Bank of St. Louis are selected to organizethe Banks annual research conference. Te privilege wasours for the 39th Annual Federal Reserve Bank of St. LouisFall Conference. Of course, a conference of this magnitudedoesnt come about through the work of only two people.

While we may have had the distinction of, as St. Louis FedPresident James Bullard noted in his opening remarks of theconference, putting this provocative program together, weare grateful for the numerous Bank employees who workedto make this conference happen.

Te rich tradition of this conference began when the firstone was held on Nov. 30, 1976. It was titled FinancingEconomic Growth: Te Problem of Capital Formationand considered the problems of generating sufficient flowsof saving and investment to finance economic growth anddevelopment in the future.

Since then, the annual conference has continued to featurethe latest in policy and frontier research. Tis years confer-ence was highlighted by yet another distinguished group ofspeakers. Specifically, this years speakers presented papers:

Measuring market frictions and their role in explainingthe labor wedge

Assessing the ability of demand stimulus to increaseinflation

Gauging the Affordable Care Acts effect on householdsincentives and work schedule decisions

Discussing job-to-job flow patterns after the GreatRecession and the effect on unemployment

Measuring financial shocks effect on matching idle labor

with idle jobs

Studying the impact of states higher education subsidieson young peoples education and migration decisions

Discovering circumstances when mandatory disclosurerequirements on banks are beneficial

Discussing regulatory reforms to promote competitionand gain greater voluntary transparency in thebanking sector

Measuring whether it is ever beneficial to require banks tohold more than their otherwise preferred level of govern-ment bonds

One of the St. Louis Feds goals is to make economic dataand research available to a broad audience. Tis conferencevolume, in which our speakers describe their work in lay-mans terms, follows in that tradition.

We thank you for your interest in the 2014 fall conferenceand look forward to the 40th conference in 2015.

William DuporAssistant Vice President


Yongseok ShinResearch Fellow


FOREWORD FROM THE

CONFERENCE ORGANIZERS


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The Federal Reserve Bank of St. Louis hosted its 39th Annual FallConference on Oct. 910, 2014. David Andolfattosat down with eachof the conference presenters and discussed their work in plain English.The content in this conference volume is based on those interviews. Allinterviews have been edited for clarity and length.

For the full conference agenda, please seehttp://research.stlouisfed.org/conferences/annual/39th.html.

The views expressed in this volume are those of the individuals presenting them and do not necessarily

reflect the views of the Federal Reserve Bank of St. Louis or the Federal Reserve System.
http://research.stlouisfed.org/conferences/annual/39th.htmlhttp://research.stlouisfed.org/conferences/annual/39th.html


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Connecting Policy with Frontier Research: Economist Interviews from the 39th Annu al Federal Reserve Bank of St. Louis Fall Conference

FERNANDO ALVAREZProfessor of Economics, University of Chicago

Paper:Mandatory Disclosure and Financial Contagion

(with Gadi Barlevy)

ANDOLFATTO

Why dont you tell us a little bit about the question thatyoure addressing in the paper?

ALVAREZ

Te general question is to study one of the aspects of thestress tests. Te stress test is one of the policy tools now usedby central banks, mainly the European Central Bank (ECB)and the Federal Reserve, to analyze how banks will fare indiffering scenarios, and then they make this informationpublic. Stress tests have other aspects, but in our paper wemostly analyze that feature.

ANDOLFATTO

Are these stress tests something new? Or is this somethingthat has been done in history? Is it something thats comeabout because of the financial crisis?

ALVAREZ

Te form of the stress test has changed more than a little bitbecause of the financial crisis. Obviously, there has always

been supervision from central banks over commercial banksand other banking institutions. But there has been a changeto make the information public, which is not something that

we have seen before. Tats the aspect that we tried to study.

ANDOLFATTOSo regulatory bodies have regularly stress tested banksbefore to see how resilient they might be under differentalternative financial stress conditions. But whats new,

youre saying here, is that theyre making the informationpublic to the community? And youre interested inwhether this is a good idea?

ALVAREZExactly. So under what conditions is this a good idea from apublic policy perspective, precisely? As you mentioned withyour question, this is new. It happened in the financial crisis.

And you see it in the academia and in the policy-makingcircles, like some of [former Federal Reserve Chairman Ben]Bernankes speeches and obviously his influence during histenure on conducting the stress test, but also in evaluatingit afterwards in the ECB. So you see it in the public policyarena, in the academia, and also in some of the practitioners,

they talked about some of the advantages. But what we wantto think about is: If they are so good, why dont banks do itby themselves?

Te idea is not that they are doing something to, you know,get banks doing something bad. Its just they are doing some-thing that in fact will help banks. It will help everybody.

So, from their perspective, if they are so good, why dont theydo it by themselves? And also, if they are so good now, is itlike somebody just discovered that now they are good andbefore people didnt realize? Or is it because of the finan-cial crisis that these are special circumstances whether theyare good or not? So then our paperlike most academicpaperstakes a stylized version of the world and tried toanswer these questions in that stylized version.

ANDOLFATTO

Tere are also conventional reasons for why this type ofinformation is not disclosed publicly, perhaps the stigmathat such a disclosure might impinge on a particular bank

thats identified as being weak. What do you have to sayabout that?

ALVAREZ

We studied a setup where sometimes its a good idea andsometimes its a bad idea, but we get a bit more precise.Te times in which its a good idea is when theres a lot ofcontagion in the sense that the fate of a particular bank isnot determined that much by how these banks operate, butby how the whole network of banks operate. For instance:During the crisis, you had a market freeze, not so muchbecause theres a large lossmaybe their losses are nothugebut we dont know where they are. So the image that

we have is there are some bad apples, but we dont knowwhere the bad apples are.

ANDOLFATTOSo the location of the risk is not known, and thispotentially poisons the whole barrel.

ALVAREZ

Exactly. So everybody doesnt trust everybody else. Te inter-esting aspect is that these are situations in which individual


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The idea for policymakers and investors is

that if a lot of people disclose information,

you could try to find the architecture of

the financial network and really see where

the bad apples lie.

ANDOLFATTOOperationally, can we observe this interlocking set ofclaims? Is this something we can see?

ALVAREZ

Te idea for policymakers and investors is that if a lot ofpeople disclose information, you could try to find the archi-

tecture of the financial network and really see where the badapples lie. Now obviously, it will always be imperfect. But theidea is that one person, only one bank, disclosing information

will give very little information about the whole network,while a lot of banks disclosing information will help a lot.

So it will be imperfect, but if you think about clearinghousesand these type of financial arrangements, theyre all like, Imtrading with you, but do I have to worry about your tradingcounterparties? Tis is an issue that financial institutionsthink about a lot. One part of the contribution of this is thatmaybe its forcing them to have to account for the social ben-efit and not just the private benefits of disclosing information.

ANDOLFATTOOn the whole then, youd say your paper is generallysupportive of the program, the stress tests?

ALVAREZ

Yes. In particular, Bernanke in the public policy arena orGary Gorton in the academia pointed out that the freeze ofmarkets in 2008 looked like, I dont want to trade becauseI dont know whether the other party will be able to payme. Tese may be the type of situations for which this isindicated.

ANDOLFATTOWhen was the first stress test implemented?

ALVAREZ

Tere have been similar types of tests elsewhere, and thentheres also the International Monetary Fund (IMF) nowtrying to encourage [them] more broadly, but mostly they arein the ECB and in the U.S. It wasnt at the very beginningof the financial crisis, but in 2009 there were two waves. Tefirst one had disclosure of this information, and this was thefirst time that it has happened.

ANDOLFATTOAnd I think I recall reading that Bernanke attributed acalming of the financial markets because of the outcomeof the information. Do you share that opinion?

ALVAREZ

Well, the bigger analysis is complicated, because the stresstest also has other features. Another feature of the stress testis that if a bank happens to be vulnerable to these types ofshocks, then it mandates that it has to raise capital. Tat

banks may not want to show that they themselves dont havethe bad apples. But if theyre all encouraged to do it, thenyou could get in a situation that is better for everybody andunfreeze the markets.

ANDOLFATTO

Under these conditions, we should observe thatindividual banks express voluntary desire to participatein the program.

ALVAREZ

If you know that the other banks do it, you are fine to do it.But if youre the only one, you may not want to do it. And Ithink the intuition is relatively simple.

Lets say that it has some cost to disclose this information andsome benefits, such as showing to potential investors in thebank or other creditors that Ive survived the stress test. Butthis also benefits you if, say, youre another bank, I owe you

some money, and now you know that Im solvent. And thenthe idea is that if you are all forced to do it, then the socialbenefits will be internalized.

Now, in a situation in which we dont trade that much, so wedont have these interlocked portfolios and your fate isnt sodependent on mine, then this wouldnt be an issue. In normalcircumstancescircumstances where theres not much what

we call contagionthen the private and social benefits wouldbe aligned.

ANDOLFATTO

Your paper makes it very clear when and when not this

type of policy of mandatory disclosure of stress testresults is a good idea socially, and you mentioned thatit all hinges on the degree of what you call potentialcontagion, the extent to which banks are interlocked.

ALVAREZ

Its the idea that maybe Lehman [Brothers] didnt have any-thing bad themselves. But then if someone else owes moneyto Lehman, I dont want to lend to Lehman.


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means its hard to know whether it was the fact that informa-tion was released or it was also the fact that they were obligedto raise capital.

On the other hand, the ECB conducted a stress test thatdidnt have the second element. It only has the informationalrelease. Where the Europeans focus on the information, they

have some other problems in their design.

It was thought by most participants that this was not a credi-ble stress test. Nevertheless, even under these suspicions, peo-ple found calming effects from the stress test in Europe. So I

will say that its hard to know. Tese are complicated. But myreading of the evidence is very supportive of Bernankes view.

To watch the interviews from the conference, visit stlouisfed.org/connecting-policy-with-frontier-research/2014.

To access the papers that were presented, visit http://research.stlouisfed.org/conferences/annual/39th.html.

The papers main takeaways, according

to Alvarez:

In moments of financial crisis, intervention thatotherwise would not be a wise policy may be

justified.

Tis is not particularly bothersome. Its mostlyabout a release of information.

Its a public policy that is reasonable from theperspective of analyzing social cost and benefit.
http://stlouisfed.org/connecting-policy-with-frontier-research/2014http://research.stlouisfed.org/conferences/annual/39th.htmlhttp://research.stlouisfed.org/conferences/annual/39th.htmlhttp://stlouisfed.org/connecting-policy-with-frontier-research/2014


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MARK BILSHazel Fyfe Professor in Economics, University of Rochester

Paper:Resurrecting the Role of the Product Market Wedge

in Recessions

(with Peter Klenow and Benjamin Malin)

ANDOLFATTO

I was wondering if you could tell us a little bit about whatyour paper is about and what the question is.

BILS

Te paper is with Pete Klenow and Ben Malin, and anythingI say shouldnt be attributed or held against them.

Te starting point is well-known, that we dont really under-stand what happens in recessions. In recessions, theres a bigdrop in employment and hours. At the same time, consump-tion drops a lot. So, given the drop in consumption andthat hours and employment are low, we would expect, and Ithink its reasonable to expect, that people would be willingto work at a lower rate of pay. So the reservation wage for

workers, what theyd require to work, should be low.

At the same time, for most recessions, productivity doesntfall that much. For the last three recessions, which is theperiod we look at, the last 25 years, on average, labor pro-ductivity doesnt really drop. So then you have this puzzle.

Why is it that people are getting laid off or that firms arentcreating jobs or the work weeks are cut, even though it lookslike the return on labor doesnt look bad? Te productivitylooks pretty good, given what people would want to work at.

Tats referred to as the labor wedge. It shows up in otherplaces in the literature. Te whole unemployment puzzle,sometimes called the Shimer puzzle, is very closely related.So thats our starting point. And then in the literature, a lotof that has been stressed as a problem from the labor market.Its natural, because youre trying to understand why labordrops so much in recessions. So its viewed as, Whats theproblem with the labor market?

And so people have looked at average hourly earnings in thedata and say, Well, average hourly earnings also dont fall thatmuch during recessions, maybe a little bit compared to pro-ductivity, but not so much. So maybe the problem is in thelabor market. Whats keeping the wages sticky or not falling?

We make a couple of points. One is we dont really knowhow to measure what the price of labor does in recessions,

because we know that firms smooth peoples wages. Newhires wages drop a lot more.

ANDOLFATTO

You mean the price of labor to the firm may not be fullyreflected in the, say, the wage that theyre earning atthat point?

BILS

Right. Suppose I dont cut all the wages for my long-termemployees, for convenience or to try to provide some insur-ance for them. Tat doesnt mean that I cant go out and findsomebody new who would be cheaper, for instance.

We show that, for various different ways of measuring theprice of labor, there is quite a drop in the price of laborcompared to the productivity. It looks like the problem isnot wage stickiness, but just that the demand for labor reallyis dropping a lot in recessions, just not in a way that we canlink to productivity.

What we show then is, in a few different ways, that if welook at lots of inputs that dont get purchased through thelabor market, we see very much the same phenomena. Ill

just mention a couple. We look at self-employed workers,and we see very much a similar phenomenon, even thoughof course they dont have any bargaining problems with theiremployers. Teyre self-employed. Tey work for themselves.

And we look at intermediates. Intermediate purchases arehuge in most industries. Its like half of the value of theiroutput. We see that the price of the intermediates drops alot, yet the inputs drop a lot, and we see the same puzzle:that the firms seem to be pulling back a lot on intermediates,

even though the productivity looks quite good.

Were basically arguing its not a problem in terms of wagesetting in the labor market. Its a more general problem offirms drawing back and being more reticent to put outputout on the market in recessions, and its just causing allfactor demands to drop.


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Well, one natural story would be that the firms are raisingtheir markups during a recession, so theyre pulling backand theyre pricing higher. Tat shows up in Keynesiansticky price models just because the prices are slow torespond. I think these effects are bigger and longer than

what one would get out of that story, in particular for theGreat Recession. We see this for all three recessions, but this

markup, this product market wedge, is particularly strikingfor the Great Recession.

So it could be price stickiness. It could be that firms feel likeits a time where, if you try to keep producing at the same

way you were, youd have to slash prices so much that itdoesnt make sense.

A paper by Simon Gilchrist, Raphael Schoenle, Jae Sim andEgon Zakrajsek shows that, after Lehman Brothers, firmsthat had cash flow problems raised their price relative to theother guys. Teir explanation was that these firms couldntafford to invest in their stock of customers. Tey had to get

money now, so they had to charge a higher price, even if itcost them some of their customer base. Tey didnt want todo it, but its just a form of cutting investment.

And I would say more generally, any decision at the marginto produce more is partly an investment. So when a firmhires a worker, its always partly an investment. You dontknow whether theyre going to be good or bad. If you really

were just hiring based on that day, would you ever hire theseguys? Tey might come in and screw things up for the day.Teres always an investment component to producing more.Because theres less investment, firms will act like, Well, Imgoing to be more reticent to produce in the recession. Andthat will show up as moving up a demand curve to a higherprice, causing an increase in price markup.

I would also mention a paper by Cristina Arellano, Yan Baiand Patrick Kehoe. Tey show that, if uncertainty goes upin a recession and firms dont want to overextend becausethey might go under and lose the whole firm, that causesfirms to be more reticent and pull back more on producingin a recession.

All these forces lead to less dynamic, less competitive mar-kets in a recession. I think it could cause markups to go up.

Tats what were arguing: People should be focused on theseother forces as well as, say, wage setting.

ANDOLFATTOIn any case, it does seem to rule out some forces, likeproductivity shocks or stuff like this.

BILS

Te acyclical data on productivity speak pretty well to that.It doesnt mean theres no role for them. But there has to be,I think, other shocks that are more important.

ANDOLFATTOTere are some people who have claimed that theres somesort of composition bias. Te workers you see laid off ina recession are the less skilled, lower productive workers.

And as these workers are laid off, this raises the averagelabor productivity of the people who keep the jobs. Do

you have any view on that?

BILS

You can calculate how big that is. And that helps to explaina little bit. You can just do sort of a back-of-the-envelopecalculation. In a recession, for every percent fall in hours,maybe three-quarters of that is employment. Te guys whoare getting laid off are maybe 20 percent less productive.

And then you can calculate that it makes a little bit of differ-ence in measuring productivity.

I can do other calculations, though, that would suggestthat productivity actually drops even less in recessions. If Ihave any overhead labor, any overhead factors, the fact that

I have to keep them on in the recession would tend to causeproductivity to drop even more. So these things tend to, Ithink, kind of offset.

Also, that compositional bias shouldnt show up for thefactors were looking at, like intermediates.

ANDOLFATTO

So your findings then would call into question theseapproaches to try and understand recessions that focuson problems in the labor market, labor market frictions,things like this, and move the focus someplace else. Likewhat, where?

BILS

Well, I would say it a little differently. We would like to saythat the focus shouldnt be only on that. I wouldnt argue thatthere arent some distortions coming from the labor marketas well as the goods market. Its just that I think the literaturehas moved to say its almost all in the labor market, and itslargely based on looking at, like, average hourly earnings.

In fact, we say this literally: We think both whats happeningto other inputs and in the goods market deserves attention inthe same way that the labor market does.

ANDOLFATTO

Do you have any, like, pet hypotheses here? Whats goingon in the product market?

BILS

Let me just say again what we see and some possible expla-nations. We see that productivity does not drop so sharply inrecessions, but the cost of a lot of inputs seems to be falling.So what could that be?


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In recessions, firms dont want to hire. I cant rationalize thatwith a productivity shock, because productivity just doesntfall enough.

ANDOLFATTOYou dont make any explicit policy recommendationson your findings, but do you see how your line of work,

your line of inquiry, might one day inform policymakersin a particular manner? Or is it too removed from thatright now?

BILS

Again, Im not speaking for Pete or Ben, of course. I dontthink in terms of policy, but I would say the following: Wedont know whats causing labor to fall in recessions. Wedont think its primarily wage stickiness. Its likely factors wedont understand well. If we recognize that we dont under-stand recessions, that has important policy implications. Youshould tread lightly. Tat would be a lesson I would take. I

wouldnt take a view based on recessions that the labor mar-

ket just doesnt work well. Tat opens the door to al l sorts ofescapades in policy.

Our work reinforces that there are costs to recessions frominefficient drops in employment. But then whats the rightpolicy response? I could say, Well, we should do thingstherefore to subsidize activity more in recessions. Butsometimes thats counterproductive. If I look at policies thatget made not according to rules, but ex-post, sometimesthey make things worse. Tey create a situation where youdont know what to do as an employer or firm because, eventhough youre not necessarily in the rent-seeking business, inthose times it pays to be.

I can give two examples. Assume were in a recession and youthink maybe well get a big investment tax credit. Maybe

we wont. Maybe itll come next year. So what should I do? Ishould invest less so that I would delay my investment untilthe tax credit kicks in.

Around 2009, there was a lot of discussion of creating asubsidy to hiring, so that if firms did net hiring, you wouldget a payment from the government. Tis is a terrible idea.Firms have to sit around and make calculations like, I dont

want to hire now, because if I do, then I lose out on the

subsidy. Better to let workers go, making room to hire whenthe subsidy kicks in.


to Bils:

Recessions look quite costly. Not just labor, butall down inputs drop sharply in recessions despitelittle fall in productivity.

We see this as a product market distortion thatcuts demands for all inputs in recessions.



60

70

80

90

100

110

120

1990 1995 2000 2005 2010

(Index

2009=100)

Business Sector: Real Output Per Hour of All Persons

Business Sector: Hours of All Persons

Productivity and Hours

NOTE: Shaded areas indicate US recessions.

Te lesson I would take is: Do nothing, or use a rule. Ifpolicymakers could credibly have a rule that, when employ-ment falls a lot, were going to have an investment tax creditor were going to have some payroll tax cut, I think ourresults could help rationalize that. But if a policymaker cantexplain and commit to what they will do under some futurescenario, then I dont think we should trust their choicesafter the fact on these policies. Tats my view, but, again,not necessari ly Petes and Bens.


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V.V. CHARIPaul W. Frenzel Land Grant Professor of Liberal Arts and Professor

of Economics, University of Minnesota; Founding Director, Heller-Hurwicz Economics Institute

Paper:On the Optimality of Financial Repression

(with Alessandro Dovis and Patrick Kehoe)

ANDOLFATTO

Tis is a very provocative kind of title, On theOptimality of Financial Repression. What do youmean by repression?

CHARI

Financial repression is a term thats often used to describepolicy measures by governments which require, in particularbanks, but more generally, other intermediarieslike sav-ings and loans, insurance companies, pension funds and theliketo hold a lot of government debt in their portfolios.Tat is, that besides private assets that they might holdlikeloans to households, mortgages and so ontheyre oftenrequired to hold a lot of government debt.

ANDOLFATTO

Would required reserves on the part of banks, forexample, constitute a form of financial repression, kind ofa legislated amount of a certain type of government debt?

CHARI

Right. ypically, these are requirements that are justifiedin terms of safety and soundness. It says that, in order for abank to meet its regulatory standards, it must hold a sufficientamount of so-called safe assets. Tese safe assets typically referto the debt of the government where this entity is located.

ANDOLFATTO

So the repression refers to the fact that these entities arerequired, kind of against their will, to hold these typesof assets, I presume. So what is the question that youreinterested then in addressing in this paper?

CHARI

Historically, this issue has largely been studied within thecontext of ensuring that banks particularly continue to besafe. But we take a somewhat different perspective on this.

We look at the broad sweep of historical experience. Oddlyenough, it turns out that whenever governments need toissue a lot of debtthe United States during the Civil Waris one example of this; more recently, weve seen this need inEuropethats when implicit or explicit regulations requir-ing financial intermediaries to hold debt seem to go up.Tese banks and similar institutions end up holding a largefraction of their portfolio in the form of government debt.

We thought that was a striking and interesting observa-tion, and so we were led to ask why. What we argue in ourpaper is that this phenomenon is very hard to understand ifgovernments can in technical terms commit to their futurepolicies. So what that means is that, if a government canchoose what policies its going to follow for a long periodof time and stick to those policies, then requiring banksto hold this kind of debt is a very inefficient way of raisingrevenue. Tere are much more efficient ways of raising therevenue needed to finance a war or of issuing governmentdebt during a recession, precisely because forcing banks todo this implies that banks will be able to finance less privateinvestment, and so therefore the economy will be worse offas a consequence of these policies.

However, what we argue is that, in a world where peopleare concerned about the possibility that governments mightdefault on their debts, either explicitly or implicitly throughinflation, then these policies remarkably start to make sense.Tey make sense because if banks and other intermediariesare holding a lot of public debt, then a default endangers the

financial system and therefore tends to make the situationa lot worse. And because the situation is going to be a lotworse, governments are dissuaded from defaulting.

Terefore, from the perspective of governments lookingahead, this mechanism turns out to be a useful device tocommit yourself to not default in a world where its difficultto convince investors that you will not default on that debt.So, paradoxically, something that is very bad, if governmentscan pick policies and stick to them, turns out in fact to bea necessary and a desirable instrument in a world withoutcommitment.

ANDOLFATTOSo what youre saying is basically that, in a worldwhere the government cannot commit to its promises,say, to repay debt, that if it forces the domestic banksto overload on the domestic sovereign debt, that thiswould increase the coststhe economic and presumablypolitical costsof the government from defaulting.

And the threat of that is what enhances the ability of thegovernment to refinance?


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CHARI

Tats exactly right. And so these forces are likely to beparticularly strong when the government needs to issue a lotof debt, because when they issue debt, investors will buy thedebt only if they think that the government is unlikely todefault. But if youve got a situation in which youve alreadyfought a warthink World War II or something like that

and youve issued a lot of debt during the war, come peace-time, you have a strong incentive to say, Well, lets defaultin part on that debt through inflation or through explicitkinds of means.

How does that help you? Tat means that valuable resourceswhich would have been used to finance other kinds ofexpenditures no longer have to be used to pay interest ongovernment debt, and so therefore the distortions that occurbecause youve got this big overhang of government debt aremuch smaller.

ANDOLFATTO

Presumably, this is not the only way government couldbuild commitment or enhance its commitment to repay.Tere are also political costs to, say, consumers andhouseholds who would be loaded up on this domesticdebt. In your paper, you dont actually focus on that.

Youre focusing on the potential costs through thebanking sector, not the political costs?

CHARI

Like any good paper, we hope, we wanted to focus on oneissue rather than take on a whole gamut of issues. And so wechose to focus our attention on this particular issue, ratherthan discuss the broader ramifications. I have a bunch ofpapers which address those broader ramifications as well.

ANDOLFATTO

You mention, and I think its pretty well-known, that itseems unusual that, say, Italian banks seem to be loadingup disproportionately on Italian sovereign debt. But wedont necessarily see any explicit government regulationsrequiring these banks to behave in this manner. Could itbe that there are natural market forces that would lead,

say, Italian banks to load up on Italian debt?

CHARI

Yes, there are some market forces. Te nature of regulationis a little complicated and a little subtle, because, especiallyas far as the banking system is concerned, private banksare in fairly close touch with their regulators. And theirregulators evaluate the safety of these banks through avariety of different kinds of metrics. Its not just specific,

written-down formulas.

We think of a lot of this kind of regulation as being implicit,not quite out in the forefront, not specifically in any written

rule or regulation. But, yes, there are perhaps other forcesthat would lead Italian banks to load up on Italian govern-ment debt. Tose forces tend to be weak because banks dohavein a reasonably competitive market systemstrongincentives to diversify their portfolios.

And so, therefore, holding Italian government debt is a par-ticularly undiversified form of risk if youre holding a lot ofItalian mortgages or loans to Italian firms, because that debtis going to become relatively less valuable exactly when therest of the Italian economy tanks. So normal market forces,youd think, would give Italian banks a strong incentive tohold German debt and German banks to hold a lot of Italiandebt. Instead, we tend to see in practice the exact opposite.

ANDOLFATTO

Suppose, for whatever reason, the Italian banks feelthat the Italian government is less likely to defaulton their sovereign debt thats held domestically. Andsuppose that this is true throughout Europe. Youd likeit to be diversified, but if what I just said was true, thissovereign debt would be relocated to its domestic sources.Tat maybe reinforces your paper. Tis is not throughexplicit government regulation, but they know that thegovernment is less likely to default if its held domestically.

CHARI

I think that is very complementary. One can certainly imag-ine those kinds of forces inducing banks to understand thatits in everybodys cooperative and best interest to hold a lotof Italian debt. So I agree. I think the kind of story you aretelling complements the story were telling fairly well.

Banks

HoldingsofGov.

Debt/BanksAssets

0

0.2

0.4

0.6

0.8

0 0.5 1.0 1.5

Total Gov. Debt / GDP

Australia

Italy

Belgium

Spain

Canada

UK

Finland Greece

US


16/36

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ANDOLFATTO

In terms of policy implications, what do you feel are themain lessons that policymakers might draw from thefindings of your research?

CHARI

A very pressing and central topic in Europe, for example,

right now is that the plan is that the European Union willhave a central regulatory and supervisory authority, which

will be run perhaps out of the European Central Bank inFrankfurt and in Brussels. And that authority will have theprimary responsibility for supervising all the banks fromPortugal to Ireland to Germany and Austria, as opposed tothe current practice, which is that the national regulatoryauthorities regulate their own domestic banks.

And an important issue thats being discussed as we speak is:How should these regulations be set up? And there are lotsof forces in Europe arguing on very sensible grounds thatnational banksbanks in Portugal for exampleshould

not hold an excessive amount of Portuguese debt. Tatmakes them vulnerable to the possibility that Portugal mightdefault on its debt. And so, therefore, they should be inducedor required to hold German debt, for example. And there aregood reasons why you might think that that proposal is agood idea.

The papers main takeaways, accordingto Chari:

Good economics always has the property thatthings that seem like a puzzle on the surface,through deeper analysis, turn out to be less of

a puzzle. Good applied economics has useful and inter-

esting policy recommendations, and I hope ourpaper has that as well.



What our research suggests is, maybe not so fast. Maybethere are good reasons why Portugal or Greece or Italy orSpain might require their own banks to hold their ownnational debt. We should take those considerations intoaccount in designing policy. Far be it from me to suggestthat the considerations were pointing out are the only onesthat should guide regulation, but we think it is an import-

ant, perhaps very important, consideration that they shouldkeep in mind. So maybe the European supervisory author-ities should think twice before it harmonizes regulationsacross Europe.


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JOHN KENNANRichard Meese Professor of Economics, University ofWisconsin, Madison

Paper:Spatial Variation in Higher Education Financing and the

Supply of College Graduates

ANDOLFATTO

Can you tell us a little bit about the questions that you arepursuing in this investigation here?

KENNAN

Teres a lot of money spent on financing higher education,mainly by the states in the U.S., and the amount of moneyspent is quite variable from one state to another, even for statesthat are quite close by, for example, North and South Dakota.

Te question that Im interested in is what the states aregetting for the money, that is, what the effects are of thedifferences in spending, and in particular whether a state thatallocates a lot more moneyby way of spending on the col-leges in the state or subsidizing the tuition payments for thestudentssees a change in the composition of the labor forcein the sense that the state has more college graduates some-time later than they would have had if they hadnt introducedthese subsidies.

Te issue, to a large extent, is whether the intervention that

affects college enrollment decisions actually sticks in theplace where its applied. Tere is an incentive for people tomove toward labor markets where they can, obviously, get thehighest return for their education. So if a state subsidizes itsstudents to acquire college degrees, the students might wan-der off and go use that human capital in some other place.

ANDOLFATTO

It would seem odd that a state would subsidize its educa-tion for students within the state only to see them leave.

What do you find? What do you discover? What is theanswer to the question of why this heterogeneity exists?

KENNANTe effects are quite substantial in terms of the choices thatstudents are making on enrollment, not just in terms ofcompleting college degrees, but enrolling in two-year collegesor community colleges and emerging with at least a partialuniversity education. So on that margin, these policies, bothchanges in expenditures and also changes in tuition levels,have substantial effects. But theres not much indication thatthe effects are dissipated through migration. Tese are people,particularly the college graduates, who migrate a fair bit.

Te exercise I do in the paper is to look at the distribution ofpeople at age 36, starting at 19, making enrollment decisions

along the way and then making migration decisions, and justcount the number of college graduates at age 36, the numberof people with some college and the number who are justhigh school graduates.

And the effects seem to stay where theyre applied. Somethingon the order of a 20 percent change in tuition or subsidiesgives rise to something like an 8 percent increase in the num-ber of college graduates in the state sometime later, like 15,17 years later. So the migration activity is pretty active, but itdoesnt undo the effects of these subsidies.

I should say these are preliminary estimates built on a model

that uses individual survey data from the Labor Department.And the estimates so far have been done just for a single state.But thats the finding.

ANDOLFATTO

You mention in the introduction of your paper that this isnot the first paper to investigate these types of questions.But whats distinctive in your paper is that the migrationis explicitly modeled. What do you mean by that? Howdo you distinguish what youve done here vis--vis whatsbeen done elsewhere earlier in the literature?

Higher Education Expenditures and

Human Capital Distribution

3.5 4.5 5.5 6.5 7.5 8.5 9.5 10.5 11.5 12.5 13.5 14.5

1991 Higher Education Expenditure per potential student

(thousands of 2009 dollars)Percentageofgraduates,

among

thosebornineachstate

24

26

28

30

32

34

36

38

40


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KENNAN

Tere are two kinds of things that have been done. One isto look at the effects of specific tuition subsidy programs,

where there are, for example, merit scholarships given outto selected individuals. I think Georgia was the first state todo this, and a number of other states have introduced it, theHOPE Scholarship.

What was measured was the effect of that kind of a sub-sidy on the decisions that these students would have maderegarding going to college or not. Te effects that were found

were quite substantial, but that doesnt answer the questionof where these people will end up. And it doesnt answer thequestion of what happens when you do that kind of subsidyfor everyone in the state, not just for a select few.

Te other kind of work thats been done is to consider look-ing at just a count of the number of new college graduates orthe number of new M.D. degrees produced within a state,and then when there is a surge in the flow of new graduates,

come back maybe 10 years laterthis is a paper by JohnBound and co-authors at the University of Michiganandask, Does that surge in the flow of new graduates correspondto a substantial increase in the stock of college graduates 10years later in the state? And the finding there was that itreally doesnt tend to stick if you measure it that way.

Whats distinctive here is not just to take the flow as some-thing thats given for some extraneous reason, but to try andthink about what would happen if you deliberately changethe flow of new college graduates by means of a specificpolicy intervention, and then, rather than just doing a countof what the numbers are now and 10 years later, keep track

of how individuals make these choices, both choices aboutwhether they go to school and choices about where they wantto live and work.

ANDOLFATTO

So your model helps identify the reasons?

KENNAN

It certainly keeps track of the reasons that people are makingthe choices, and it allows you to think about the choices thatthey would make under alternative arrangements and alterna-tive policies that they might face.

ANDOLFATTODoes your paper speak at all to the reasons for the

variation that we do see in subsidies?

KENNAN

Not really, and thats somewhat mysterious. Te subsidies,the amount of money thats allocated for higher education isvery substantial. And, of course, that has to be financed bytaxes on the residents of the state. So the people who end up

as college graduates are in some sense paying for themselves,but the people who end up not going to college are also pay-ing for the college graduates.

Tese kind of policies involve an implicit transfer from peoplewho dont have so much money to begin with and giving themoney to people who already have quite a bit, so a transferfrom someone who is a high school graduate to someone

who is a college graduate. Tats a little surprising to see. osee that these decisions are made very differently across theU.S., thats not something that the paper really addresses.Indeed, it treats those variations as the outcome of some,perhaps political, process where its largely accidental how thenumbers turn out. But thats a very interesting question in itsown right.

ANDOLFATTOPerhaps not this paper, but this line of inquiry yourepursuing, how might it feed into the policy debate?How might it inform policymakers? Do you see any rolefor your findings in how educational policies might bedesigned going down the road?

KENNAN

I think it brings up the question of whether its beneficial forthe residents in the state as a whole to augment the level ofeducation in the state labor force. You will see the argumentmade that, by having a more educated workforce, everybody

benefits, not just the people who have the extra education,but that it spills over to the others in the state as well. It cre-ates jobs. It enhances the labor market in some way.

I dont really get into that in this paper, but, certainly, youwant to knowif thats your view of how the labor marketworkswhether these large expenditures are actually goingto pay for themselves in the long run through some mecha-nism like that.

Migration

23 24 2 5 2 6 2 7 2 8 2 9 30 3 1 3 2 3 3 3 4 3 5 3 6 3 7 3 8 3 9 4 0 4 1

Percentage of graduates, among those born in each state

Percentageofnative

graduateswhostay

20

25

30

35

40

45

50

55

60

65

70


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to Kennan:

Te decisions that people are making seemquite purposeful.

If you think about the reasons that lie behind the

choices that people make about going to college ornot, going to college for a year or two and whetherto continue, or going to a community college andfinishing in a four-year college, there seems to besome evidence that these choices are quite system-atic and that the subsequent migration choices aresimilarly quite systematic.

You can actually predict what the consequencesof changes in different policy variables will be,and I think thats encouraging.

ANDOLFATTO

Tere are many ways to attract human capital to alocality, such as offering an environment thats conduciveto entrepreneurs or startups, that would be independentof where they were educated. But I think what youregetting at here is the suggestion that the homegrowntalent is eventually going to come back, that the locals

who are financing this endeavor can rest assured thatyour findings suggest that they will be coming back andcontributing.

KENNAN

One thing thats really important in looking at migrationdata is that there is a very strong tendency for people to wantto live where they grew up. Tey will leave in many cases,but theyll often come back. So if youre trying to change thecomposition of the workforce in the state, you might try todo it by attracting college graduates from other places, butits likely to be much more effective to produce more collegegraduates from your home population, because those are the

people who are most inclined to be in this location in thelong run.




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ANDOLFATTO

Would you mind telling us about your paper?

LEVINE

I want to investigate what happens to the quality of informa-tion that banks disclose to the public and to regulators afterregulators reduce impediments to competition among banks.So the general issue is: If theres a regulatory change thatallows banks to compete with each other, so one bank canenter another banks market, does that have an effect on thequality of information that they disclose?

ANDOLFATTOQuality in the sense of the quality of their balancesheet, the information contained in the regularstatements required?

LEVINE

All firms, all corporations, including banks, have incomestatements and balance statements where they describe howmuch profit theyre making and what their assets are. And

they can do things with their accounts to make themselveslook a little bit better or look a little bit worse.

When we talk about information disclosure, its the degreeto which they are manipulating that information in order toperhaps pass muster with the regulators on capital require-ments or in order to look a little bit better in terms of profits.Or they could even make themselves look a little bit worse ifthey want to discourage new entrants as a way to signal thatthe markets not very profitable.

ANDOLFATTO

What particular regulations do you have in mind here, or

deregulation?

LEVINE

We look over a particular period in the U.S., starting in themid-1970s and going through to about 2000, when there

was a series of regulatory reforms that reduced impediments.

For example, one type of reform eliminated restrictions onbanks being able to set up branches within their own state.

For a long time in the U.S. and in many states, there wererestrictions on how many banks, how many subsidiaries,how many branches a bank could actually have. Tose wereremoved, and that meant if I was in one part of the stateand you were in another part of the state, I could set up abranch and compete with you. And that was disa llowedbefore by regulation.

Ten there were other regulatory changes. For example, ifIm in California, youre in Missouri, and you want to openup a bank in California, for a long time in the U.S. for mostof the 20th century, you couldnt do that. And these restric-tions were removed.

Tere were a variety of other restrictions that slowly allowedbanks to be able to compete with each other more vigorously.

ANDOLFATTO

Regulations come. Tey wax, and they wane. Is there apresumption of what additional competition or the lackthereof has in terms of bank opacity?

LEVINE

Whats nice from a research perspective, and I think alsofrom a policy perspective, is that it could go either way.

For example, many people argue that competition improvesefficiency. If this bank is going to be under threat, then itsinvestorspotentially both bondholders and stockholdersare going to monitor that institution much more carefullyand perhaps induce it to provide much more accurate infor-mation and not play around with the numbers.

At the same time, if a bank or another firm is under a threat,

insiders may see that their horizons are short, and they maywant to manipulate the information more intensively inorder to get bonuses because the firms long-term prognosisis not so great.

From a theoretical perspective, it could go either way. Tishas implications for us today because its about what typesof policies are going to make it easier for the private sector toassess whats going on at a bank, and also for regulators.

ROSS LEVINEWillis H. Booth Chair in Banking and Finance, Haas School of Business,University of California, Berkeley

Paper:Competition and Bank Opacity

(with Liangliang Jiang and Chen Lin)


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ANDOLFATTO

Yours is largely an empirical investigation. Teres a broadclass of theories that can go one way or the other. And now

youre taking a look at some evidence. What evidence inparticular are you looking at?

LEVINE

What we do is we look at these regulatory changes that takeplace in different states over different times, and we havemeasures of the degree to which the bank is manipulating itsinformation before there was a regulatory change, and then

we see what happens afterwards.

ANDOLFATTO

Give an example of evidence that you have ofmanipulation, how you can identify that in your data.

LEVINE

Te accounting profession has many models of trying topredict or explain loan loss provisions. Loan loss provisionis when a bank takes aside some money and puts it into anaccount and says, Were worried that some of our loans maynot pay off, and we want to have this money there just incase theres a problem.

When the bank does that, it lowers its income in that period,and it increases measures of capital. Te bank can use thattype of discretionary loan loss provisions. Maybe they dontreally need to have loan loss provisions, but they do it any-

way. Or maybe they want to boost their profits and look bet-ter to potential buyers, and then that way theyll take moneyout of loan loss provisions, and that comes in through theincome statement and looks like a profit.

ANDOLFATTOBut how can you tell whether this loan loss provisioning iswell-intentioned, or just for window-dressing purposes?

LEVINE

Tere are two ways we do this. One way to do this isthrough a statistical model, and this again comes from the

accounting profession. We predictusing all the informa-tion we canwhat we expect loan loss provisions to be,how much we think banks are going to put aside. Ten, welook at the difference between our prediction from a modeland whatevers left over. We can see whether that amount ofignorance, that measure, changes systematically before andafter a bank faces competition.

Te other way we do it is that banks also will restate theirearnings. What that means is they put together their loanloss provisions. Tey release this information to the publicincome statements and balance sheets. Ten sometimes a fewquarters later, theyll go back and theyll say, Oops, were

going to restate it. So we also look at that, because thats avery direct measure of whether the bank had to change itsaccounts ex-post.

ANDOLFATTO

Restating financial reports is very common, but youretrying to discover whether this occurs more systematicallyunder one regulatory regime vis--vis another, I guess.

LEVINE

Exactly. We get measures of how much of this type ofrestatement is taking place before a big change, how much istaking place after or in the earlier measure where we have astatistical model, and we assess how much of this manipula-tion seems to be taking place and whether it changes. What

we find is that its a very big change. It goes down by about40 percent.

ANDOLFATTO

It goes down because of the regulations that permittedmore competition in the United States? Tese measuresgo down?

LEVINE

Exactly. What happens is the measures of competition go up.

So as regulators remove barriers to competition, I can comeover to your neighborhood. You can come to California.What we see after that is, both you and I, because were sub-ject to greater competition, we manipulate our earnings less.We restate our financial accounts less frequently.

ANDOLFATTOAccording to your estimated model of loan lossprovisioning, you estimate that this kind of window-dressing tool is used less frequently in a more competitive

We get measures of how much of this

type of restatement is taking place before

a big change, how much is taking place

after or in the earlier measure where we

have a statistical model, and we assess

how much of this manipulation seems to

be taking place and whether it changes.

What we find is that its a very big change.

It goes down by about 40 percent.


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20


regime? So your empirics lend support to one side of thetheoretical debate and argue that increased competitionpromotes transparency?

LEVINE

Correct.

ANDOLFATTODo you have a view as to whether this is a good thing?Tere are cases that could be made that some degree ofopacity is kind of desirablelike the Fed, for example,does not disclose the identity of, say, the agents who makeuse of the emergency lending facility, or at least delaysthe disclosure. Do you have a view, or does your analysissuggest anything, about the desirability of these types ofincreased competition leading to greater transparency?

LEVINE

Teres a long series of papers that examine the relation-ship between bank opacityor the degree to which banks

manipulate their accounts, the degree to which there arerestatements of their earningsand bank performance.

What I mean by bank performance is youll see that bankstend to be less stable, more fragile, when they manipulatetheir earnings more. And this exists in other firms as well.

You also tend to see that lending becomes less efficient andmuch more subject to the vagaries of the business cycle whenbanks are more prone to manipulate their earnings or restatetheir financial accounts.

Regulators also have a harder time following the banks whentheir financial accounts are not as accurate as they could be.So there seem to be these implications for bank behavior ofthe degree to which banks manipulate their earnings. Ourcontribution is to assess this question: Well, this one typeof policy changewhether increased or decreased competi-tionwhat was its impact on the bank? And its the degreeto which it manipulates earnings.


to Levine:

Competition tends to reduce lots of inefficienciesin banks.

We should be worried about policies and develop-ments that are going to reduce competitionamong banks.



ANDOLFATTO

Lets take a look at the Canadian banking system inparticular, which most people would characterize as lesscompetitive than the United States. And yet its widelyknown that it displayed much more resilience during therecent crisis in particular. Do you have any views on that?Have you looked at other countries?

LEVINE

In this particular study, I havent looked at other countries.One of the nice things about looking at U.S. states is that wecan hold lots of other things constant. Obviously, if you lookat Canada and you look at the United States, the differencesare going to be much more substantial. And its hard toisolate the effect of one thing, like competition.

ANDOLFATTO

So competition is good for transparency, and transparencylargely provides a more resilient, more accountablebanking sector.

LEVINE

Yes, and I think its relevant for today, because especiallyafter the crisis, we have greater consolidation, perhaps afeeling of too big to fail on the part of investors and banks.Tis might be interpreted as an increased regime in whichtheres less competition.

What this paper talks about is not just the history from the70s and the 80s, but it also speaks to whats going on nowin terms of regulatory policies that might infringe on compe-tition and the contestability of markets.


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ANDOLFATTO

Youre looking at some empirical evidence behind therelationship between demand stimulus and inflation.Can you tell us a little bit about the exact question

youre addressing?

MANOVSKII

If you dont mind, Ill start a little bit further back, whichmight be helpful.

If you look at what happened in the U.S. economy in 2014until now, what surprised a lot of people was an unex-pectedly strong recovery of labor markets. Unemploymentdeclined substantially and employment increased substan-tially, so there is a roughly proportional flow of peoplefrom unemployment into employment. Vacancies are at anall-time high.

What caused this unexpectedly strong recovery? Onething that comes to mind is that, in January 2014, massiveextensions of unemployment benefits, which started during

the Great Recession, came to an end. And it could be thatsomehow that expiration of unemployment benefits causedthe recovery in the labor market.

So how would the story work? Its very simple. When youprovide benefits to people, people tend to demand higher

wages in equilibrium, so wages go up. If productivity ofworkers stays the same, but firms have to pay higher wages tothose workers, they have to hire fewer workers because prof-its decline and job creation goes down. Tats not to say thatpeople are lazy. Its not to say that people dont want to work.Everybody wants to work. Its just in equilibrium firms knowthat after they hire workers they will have to pay higher

wages relative to workers productivity, and that causes adecline in job creation, an increase in unemployment and adecline in employment.

Tis was the theory assessed in the paper that I wrote ayear ago with Marcus Hagedorn, Kurt Mitman and FatihKarahan where we very carefully measured the effects ofunemployment benefit extensions and found very sizablenegative effects on employment. Unemployment benefitextensions also increase unemployment and cause a declinein job vacancies.

ANDOLFATTO

Negative in those measures, but the insurance aspectscould have had positive effects?

MANOVSKII

Exactly. One of the aspects in which our research was criti-cized was as follows. Te argument was made by the Councilof Economic Advisers and by the Congressional BudgetOffice that, Look, unemployment benefit extensions is oneof the best stimulative policies out there. It provides moneyto people, who would spend that money, will stimulateaggregate demand, will stimulate the economy and couldhave substantia l positive effects on the economy.

And so the real motivation for this paper is trying to eval-uate, Is it really happening? Is the effect of unemploymentbenefit extensions on demand stimulus really as big as themodels that policymakers are using suggest it is?

ANDOLFATTOYoure asking if the demand stimulus effect of, say,

extending unemployment insurance benefits is as large asthese models suggest. But what does the evidence suggest,first of all?

MANOVSKII

Its very hard to measure the effect of stimulus and to knowdirectly whether stimulus has a big effect or a small effect.Suppose there is a state that has a lot of unemployment. Youincrease stimulus there, and you see that the economy recov-ers a little bit. Its not clear if it recovers a little bit due tostimulus and the stimulus effect is not too big, or maybe theconditions in that state or that location were bad and maybeeven becoming worse. So its generally very difficult to tease

out how big this effect is.

And this is not what Im doing in this paper. Instead, whatI really want to assess is the quality of the models that poli-cymakers are actually using and that generate big effects ofstimulus. Are those models consistent with what we observein the data or not?

ANDOLFATTOSo the models that justify, in policymakers minds, thepositive effects of these types of stimulus programs, youre

IOURII MANOVSKIIAssociate Professor of Economics, University of Pennsylvania

Paper:Demand Stimulus and Inflation: Empirical Evidence

(with Marcus Hagedorn and Jessie Handbury)


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interested in taking their models and interpreting theevidence to see to what extent their models are consistentwith this idea that this type of stimulus in particular iseffective. Is this the idea?

MANOVSKII

Tats an excellent description of what we do.

ANDOLFATTO

ell us exactly then: What do you do, and which model doyou have in mind of evaluating?

MANOVSKII

Let me explain how standard models work and how poli-cymakers usually think about it. Teir reasoning is usuallybased on models in which prices are sticky. Tat is, there issome friction that prevents firms from adjusting prices. Now,suppose you provide money to people, and they spend thismoney to buy stuff. Tis increases demand that firms face, sofirms, given that they cannot adjust prices, sell more.

What happens? People know that eventually firms will adjustprices, so prices will go up. And now consider the case ofthe zero lower bound on interest rates or the notion of theliquidity trap, which a lot of people argued characterized theeconomy in the last few years. Simply put, the idea is thatthe nominal interest rate is fixed at some low level.

And so then if you expect prices to go up, it means that youwant to buy today. You dont want to delay your purchasesinto the future. In more formal economics terms, it meansthat real interest rate has to decline today, and this inducespeople to go out and buy stuff today. And this reinforcesthe effect of the original stimulus. People go out, they spendmore, it amplifies the effect, and you can generate big stimu-lative effects from these policies.

ANDOLFATTO

In the context of these models that youre interested inevaluating, when the nominal interest rate is at its lowerboundwhich it is todaythis type of stimulativeprogram means: You write checks for people. Teyregoing to spend more. Firms are going to increase theirproduction, and people are going to foresee that prices aregoing to rise in the future

MANOVSKII

And they want to spend even more today.

ANDOLFATTO

So this induces them to spend now before the prices rise?

MANOVSKII

Exactly. And why it might not happen outside of the zerolower bound is that it could be that monetary policies ofcentral banks can undo some of those effects otherwise.

ANDOLFATTO

So this type of stimulus program will generate aninflation. Tats what the standard model predicts. Howdo you evaluate this?

MANOVSKII

Tats exactly where this paper comes in. We want to seewhether unemployment benefit extensionsso spending onbenefitsreally changes inflation in the way that is consis-tent with these models and in the way that is consistent withbig, sizable stimulative effects of those policies.

We identify counties in the United States which belong todifferent states but border each other. Now, unemploymentbenefit extensions are set at the state level. When economicconditions trigger unemployment benefit extensions, theyare extended at the state level and apply to all counties

within the state. Tis is the key part: Its not the economicconditions of a particular county that determine unemploy-

ment benefits in the state. Its the total effect of the economicconditions in the state that determines the benefit policy thatapplies to all counties. And then by looking at two countiesthat border each other but belong to different states, we canisolate the effects of spending on benefits by observing whathappens to prices and inflation. In those locations, we canidentify the effect of stimulus spending on inflation.

ANDOLFATTO

So the idea is to consider two counties that border eachother that are in different states and consider one statethat, say, enacts an unemployment insurance extensionprogram. Ten, you want to study the behavior of thesetwo counties that border each other to see if they reactdifferently. And suppose they react differently. What do

you discover then?

MANOVSKII

In the class of models that policymakers are using, thereis a particular mathematical relationship called the NewKeynesian Phillips curve. It has a very intuitive interpreta-tion. It says that inflation today is proportional to how costlyit is for firms to produce the last unit of output they areproducing plus expected inflation tomorrow.

ANDOLFATTO

So inflation is a function of what firms believe to be thecosts of production, not only today but also

MANOVSKII

Going forward, because remember prices are assumed tobe sticky. If prices are sticky, it means firms may not beable to adjust prices for some time even if their costs ofproduction change.


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2

ANDOLFATTO

So they have to make a forecast of how their costs aregoing to evolve in the future. How does this relate into

extension of unemployment insurance program?

MANOVSKII

Extensions of unemployment insurance programs mean thatyou provide a transfer. Recall its very important that theseextensions are financed at the federal level.

When the unemployment benefits go into a particularcounty, its a pure transfer of resources into that county.

When the resources enter the county, you would expectprices to go up, and you would expect marginal costs of thefirm to go up because now firms have to hire more workers,

they have to ramp up production and costs of doing so go up.

ANDOLFATTO

What youre saying is that the unemployment insurancebenefits extension in the one county should stimulatemore inflation vis--vis the neighboring county that didnot. Tats the implication of the theory?

MANOVSKII

Yes, but with one caveat. Its very important to measureinflation in a way that is consistent with the model. Its not

just pure inflation. Its so-cal led quasi-differenced inflation.Its inflation today minus expected inflation tomorrow. Its

this object that is related to the cost of producing for firmsin the model. By looking at the data through the lens ofthe model, its this change in prices that informs us aboutthe changes in costs of firms and about the potential size ofstimulative effect.

ANDOLFATTO

What sort of data do you have that permits you to identifythis object?

MANOVSKII

We use Nielsen retail scanner data. Its a dataset which hasapproximately 40,000 retail stores, and we see the sales of allthe goods they sell at a weekly frequency, the volumes theysell and the prices at which they sell each good.

When we look at those prices, they do not evolve in the way

that the standard model would predict. In particular, theevolution of prices suggestsif you interpret that evolu-tion of prices through the lens of the standard model withsticky pricesthat the costs that the firms are facing are notaffected by fiscal stimulus. Tis basically means that fiscalstimulus or transfers of resources to a county do not drive upthe costs of the firms, they do not drive up expected infla-tion, and so they cannot have any stimulative effect.

ANDOLFATTO

It had no effect on inflation, but these unemploymentinsurance checks, did they stimulate spending?

MANOVSKIIYes.

ANDOLFATTO

Without driving up marginal costs?

MANOVSKII

Again, its a little bit of a subtle question. Tey do not drivemarginal costs or costs to the firm only if you measure thosecosts the way the models the policymakers are using tell youthose costs have to be measured.

You can measure it in a much simpler way. For example, youcan ask, Do total sales of firms increase when consumers ina county receive transfers? And the answer is yes, so thosetransfers do increase sales and consumer spending.

You can also just look at prices, without measuring them in away consistent with those models, that is, without taking thedifference between the prices and expected prices tomorrow.If you just look at prices in this way, you see a fairly strongresponse. Prices do go up in counties that receive transfers.

In this sense, there are stimulative effects of these policies. Ifyou try to interpret those effects through the lens of sticky

price models on which policymakers rely, you would say thatthose effects are not there.

ANDOLFATTO

Tats a very subtle point youre trying to make. Whatyoure suggesting is that these types of programs maybe stimulative but not for the reasons that policymakerstypically think. Would that be fair?

By looking at two counties that border

each other but belong to different states,

we can isolate the effects of spending

on benefits by observing what happens

to prices and inflation. In those locations,

we can identify the effect of stimulus

spending on inflation.


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MANOVSKII

Tats a fair interpretation. Essentially, if you really believein the class of models that policymakers are using, thosepolicies are not stimulative, or theyre stimulative but not forthe reasons underlying those models.

Its natural to expect some stimulative effect even if you

take a pure, frictionless model with no frictions on prices,for example. In those models, transferring resources to aparticular county would stimulate spending at least to someextent, so you would expect some effect along the lines of

what we find. What you do not find is this big amplificationof the effect through the sticky prices mechanism underlyingpolicymakers thinking.

ANDOLFATTO

Te policymakers that are relying on these types ofmodels to organize their thinking on other matters, theymay be flawed I suppose is what youre saying. Are therecompeting models that might do better? Do you talk at all

about them?

MANOVSKII

We do some. In particular, we look at one class of modelswhich also feature pricing frictions: the sticky informa-tion-type models. Te idea there is that once in a while, letssay, the grocery store managers make a forecast of how theyexpect the economy to evolve. Tey program their comput-ers, they program a pricing plan, and so there are prices thatevolve over time according to those pre-specified plans. Andpeople infrequently update those plans in light of the newinformation that they collect. Its just too costly to do it veryoften, so people only update those plans occasionally.

ANDOLFATTO

Teres a competing model that potentially does better.Teres the conventional one that doesnt do so well. Whatsort of mistakes might policymakers make by relying onthis model vis--vis the one that you just described thatdoes a bit better? Would they imply different types ofapproaches to stimulus?

MANOVSKII

Te question is, How big are the effects of stimulus? Testicky information model would predict much smaller effects

of stimulus than the original model, so the wisdom of stimu-lative policies could be called into question.


to Manovskii:

A lot of well-intentioned policies could have verynegative impacts which counter the originaldesign. For example, the policy of unemploy-ment benefit extensionseither motivated byits potential stimulative effects or by the desireto help unemployed peoplemay actually hurtunemployed people.

Tis is not because the unemployed are some-how lazy. On the contrary, unemployed peopleare desperate to work. However, unemploymentbenefit extensions improve workers well-being

when they are out of work. Tis puts an upwardpressure on wages of those employed. Faced witha fixed level of workers productivity but higher

wages due to the policy, firms are not creatingjobs because it becomes more difficult to coverthe costs of job creation. And those unemployedsimply do not get a chance of having a job. Sothe well-intentioned policy which tries to help

unemployed people can actually hurt unemployedpeople and hurt them substantially.

We have to be really, really careful about thinkingand understanding the effects of these policies. Inparticular, the models on which policymakers relyand which imply large stimulative effects are notconsistent with the data.



ANDOLFATTOHow many data points do you have in your paper inthe dataset?

MANOVSKII

A lot. In the dataset on prices we have 76 billion observa-tions. Its a massive amount of data.


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GIUSEPPE MOSCARINIProfessor of Economics, Yale University

Paper:Did the Job Ladder Fail After the Great Recession?

(with Fabien Postel-Vinay)

ANDOLFATTO

Describe for us what exactly a job ladder is and what itmeans for it to fail.

MOSCARINI

I think everybody understands that there are high-payingjobs and low-paying jobs, and, in life, people slowly climbwhat we call a job ladder, meaning they slowly and by luck,by and large, find these higher paying jobs and occasionallyfall off the ladder. Tey get fired, and this has long-lastingconsequences for their earnings for a long time.

What we do in this research project, with my co-authorFabien Postel-Vinay from University College London, islook at what this job ladder implies for business cycles, whyso many people lose jobs in recessions, why it takes so longto regain employment out of recessions and why the jobrecovery has been so slow. In past work, we actually looked atmany recessions and many business cycles in many countries.In this work, we actually focus on the Great Recession, onthe last cyclical episode, and we do find something different.

Let me tell you a little story for basically what we distilled outof the research project and why the Great Recession is differ-ent. When unemployment is high, its actually easy for firmsto hire. Tere are plenty of people knocking on the door. Itsactually particularly easy for small firms, which are low-pay-ing firms, to hire. Tey dont lose workers to other firms,there is no poaching, there are no quits, everybody is desper-ate for a job, and so small firms are relatively unconstrained.

When unemployment is lowas hopefully it will be in theU.S. in a year or so, as its already fallingit gets muchharder for firms to hire. So large firms start poaching people

from small firms and the job ladder really picks up. Tis iswhat we see in the data. Small firms, as a consequence, actu-ally do relatively well relative to large firms in recessions andearly recoveries. So small firms actually are the engine of jobcreation, as many people say, but only when unemploymentis high, which is probably when jobs are needed. And whenthe economy tightens, large firms are actually leading thecharge, and thats where wages really rise.

Now, the Great Recession has been different. Somethinghappened, something we dont actually dig into, that made

small firms suffer more than in previous episodes. Overall,they still did just as badly as large firms, but usually they dobetter in recessions. Tis all sounds counterintuitive, becausemost people have in mind that small firms are the ones whosuffer more in recessions. Teir credit is tighter, but the dataspeak quite strongly in favor of the pattern that I described.

In this particular recession, small firms did suffer. Whathappened was that there was no room created at the bottomof the job ladder because the small firms were suffering. Tey

were not hiring, large firms were not poaching, the job lad-der stopped working, and so these jobs at the small firms

which are the typical gate of entry for unemployed intoemployment or re-entry for the unemployed into employ-mentdidnt open. Tese jobs at the bottom were not there.

Now, why is that? Why did this happen? We have differentconjectures about why these quits decl ined. People maybe

were scared about quitting their job and taking a gamblewithout a job because unemployment was so bad. But thatsessentially what happened.

Ten we looked at a host of data to corroborate this story,and we actua lly find that the movement of people up the

job ladder is probably the one indicator of the labor marketthat has still not recovered. Unemployment has come down,employment has gone up, hiring rates are healthy again, but

39th Annual Federal Reserve Bank of St. Louis Fall Conference

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