SPRING 2005 THE FEDERAL RESERVE BANK OF RICHMOND ... · Searching for the Hidden Economy:...

T H E F E D E R A L R E S E R V E B A N K O F R I C H M O N D

S P R I N G 2 0 0 5

AFFORDABLEHOUSING . . .AFFORDABLEHOUSING . . .Are home pricessoaring beyond your reach?

Underground Economy • Sticky PricesBiometrics • Interview with Thomas Schelling

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C O V E R S T O R Y

Homeward Bound: Housing markets work just fine for mostpeople. But certain markets in the Fifth District aren’t produc-ing homes and apartments that working families can afford

F E A T U R E S1 6

Searching for the Hidden Economy: Economists believe as muchas 10 percent of the U.S. economy is “underground.” Is that sucha bad thing?The hidden economy takes many forms – from scrip currency in ruralAppalachia to walk shoveling in Richmond, Va. — and it’s not always assinister as it sounds. But the size of the underground economy is as muchin debate as its meaning.

2 0

Sticky Situation: Some prices are slow to change. Are they stickyenough to affect monetary policy?Nobody doubts their existence, but many question their importance.Some leading economists, including a widely cited Richmond Fedresearcher, hold sharply divergent views about the importance of stickyprices and their impact on the economy.

2 4

The Dollar Dilemma: The falling dollar has made Americangoods more attractive to consumers abroad, but not everyoneis happy about the currency’s slideThe dollar’s decline has been good news for many Fifth District firms.Whether further depreciation portends wider trouble for the U.S.economy remains to be seen.

2 6

The Identity Business: Biometrics cluster sharpens WestVirginia’s economic imageThe Federal Bureau of Investigation’s Criminal Justice InformationServices Division in Clarksburg, W.Va., has spawned a cluster of businessesrelated to biometrics, the science of measuring physical characteristics todetermine identity.

3 0

The Future of Community Banking: A decade ago, small bankswere being gobbled up by big banks, but those days seem to beover. What are they doing now?The economic role of community banks has evolved over the past 20years, and nowhere is that more apparent than in the Fifth District.

D E P A R T M E N T S

VOLUME 9 NUMBER 2SPRING 2005

Our mission is to provideauthoritative information and analysis about the Fifth Federal Reserve Districteconomy and the FederalReserve System. The FifthDistrict consists of the District of Columbia, Maryland, North Carolina,South Carolina, Virginia, and most of West Virginia. The material appearing inRegion Focus is collected anddeveloped by the ResearchDepartment of the FederalReserve Bank of Richmond.

D I R E C T O R O F R E S E A R C H

John A. Weinberg

E D I T O R

Aaron Steelman

S E N I O R E D I T O R

Doug Campbell

M A N A G I N G E D I T O R

Kathy Constant

B U S I N E S S W R I T E R S

Charles GerenaBetty Joyce Nash

E D I T O R I A L A S S O C I A T E

Julia R. Taylor

C O N T R I B U T O R S

Joan CooganAndrew FoersterEric NielsenChristian PascasioJennifer Wang

E C O N O M I C S A D V I S E R S

Andrea HollandRobert LacyRay Owens

C I R C U L A T I O N

Walter LoveShannell McCall

D E S I G NAilsa Long

Published quarterly by the Federal Reserve Bank of RichmondP.O. Box 27622Richmond, VA 23261www.richmondfed.org

Subscriptions and additionalcopies: Available free of charge by calling the Public Affairs Division at (804) 697-8109.

Reprints: Text may be reprinted with the disclaimer in italicsbelow. Permission from theeditor is required beforereprinting photos, charts, andtables. Credit Region Focus andsend the editor a copy of thepublication in which thereprinted material appears.The views expressed in Region Focusare those of the contributors and notnecessarily those of the Federal ReserveBank of Richmond or the Federal Reserve System.

ISSN 1093-1767P H O T O G R A P H Y : S T O C K B Y T E / G E T T Y I M A G E S

C O V E R S T O R Y1 0

Homeward Bound: Housing markets work just fine for mostpeople. But certain markets in the Fifth District aren’t produc-ing homes and apartments that working families can affordFrom Washington, D.C., to Charlotte, N.C., much of the Fifth District’ssupply of new housing consists of spacious, pricey homes. This has putthe squeeze on people earning at or near the median. Analysts point toland-use restrictions as a key culprit behind runaway housing costs.

F E A T U R E S1 6

Searching for the Hidden Economy: Economists believe as muchas 10 percent of the U.S. economy is “underground.” Is that sucha bad thing?The hidden economy takes many forms – from scrip currency in ruralAppalachia to walk shoveling in Richmond, Va. — and it’s not always assinister as it sounds. But the size of the underground economy is as muchin debate as its meaning.

2 0

Sticky Situation: Some prices are slow to change. Are they stickyenough to affect monetary policy?Nobody doubts their existence, but many question their importance.Some leading economists, including a widely cited Richmond Fedresearcher, hold sharply divergent views about the importance of stickyprices and their impact on the economy.

2 4

The Dollar Dilemma: The falling dollar has made Americangoods more attractive to consumers abroad, but not everyoneis happy about the currency’s slideThe dollar’s decline has been good news for many Fifth District firms.Whether further depreciation portends wider trouble for the U.S.economy remains to be seen.

2 6

The Identity Business: Biometrics cluster sharpens WestVirginia’s economic imageThe Federal Bureau of Investigation’s Criminal Justice InformationServices Division in Clarksburg, W.Va., has spawned a cluster of businessesrelated to biometrics, the science of measuring physical characteristics todetermine identity.

3 0

The Future of Community Banking: A decade ago, small bankswere being gobbled up by big banks, but those days seem to beover. What are they doing now?The economic role of community banks has evolved over the past 20years, and nowhere is that more apparent than in the Fifth District.

D E P A R T M E N T S

1 Noteworthy/Encouraging Homeownership — at What Cost?2 Federal Reserve/New Times for Fed Branches5 Policy Update/Tax Increment Financing6 Jargon Alert/Zero-Sum Game7 Research Spotlight/Causes of Terrorism8 Short Takes

32 Economic History/Making Furniture in North Carolina’s Piedmont36 Interview/Thomas Schelling42 Book Review/Fighting Poverty in the U.S. and Europe:

A World of Difference44 NEW Regional/District Economic Developments52 Opinion/Evil Empire?


As the cover story of thisissue of Region Focus makesclear, affordable housing

is a significant problem for manyAmericans. There are several rea-sons for the mismatch betweenconsumer demand on the onehand and market supply on theother. In particular, land-use regulations appear to be an important factor driving up pricesin some of the Fifth District’s

highest growth regions. Policymakers should consider thecosts such regulations impose on society before enacting or expanding these rules.

Reconsideration may also be worthwhile for the domi-nant policy response to shortages of affordable housing. Ingeneral, governments have preferred to subsidize the con-sumption of housing in various ways rather than to providecash transfers to support the incomes of those most hurt byhigh housing costs. But it’s not clear that this approach is aparticularly efficient means of helping such consumers. Itmay have induced them to obtain more housing and less ofother goods than they would have in the absence of suchsubsidies. Providing people with cash transfers, in contrast,would be a more direct solution to the problem and wouldlet them choose how best to allocate their resources. It is awell-established economic principle that the provision ofcash or cashlike assistance is the most cost-effective way toimprove the well-being of low-income households. There is really nothing special or different about housing that sug-gests that deviation from this principle is warranted.

So if cash transfers would be a more desirable policy re-sponse, why do we subsidize housing instead? One reason— associated specifically with homeownership — may be thesupposed “positive externalities” associated with ownership.Many believe that benefits accrue not just to the home-owners but to the larger community as well. For instance,several studies have suggested that homeowners tend to bemore active in their communities, by participating in char-itable, social, and political groups at relatively high rates.Others have claimed that homeowners tend to lead health-ier, happier lives, thus reducing total public expenditures onmedical care. And, finally, some have argued that home-owners generally take better care of housing than do renters,contributing to more pleasant, stable neighborhoods.

The last argument seems consistent with economic theory. We would generally expect owners to maintain thingsbetter than people who are just temporary stewards of the

property. And insofar as landlords often have difficulty assessing the character of prospective renters or monitor-ing their behavior once they have moved in, we might expect that rental properties will receive less care from theiroccupants.

The other examples of positive externalities discussedabove may have causation problems, however. Communityactivism and personal health could be associated with home-ownership but not a result of it. We know that, on average,homeowners tend to be wealthier than renters. But we alsoknow that wealthier people tend to be more active in theircommunities as well as healthier than those near the bottom of the income distribution. Which factor — home-ownership or wealth, or even some other, unobserved factor that is correlated with both of these — is driving higher rates of community activism and health? It’s not obvious.

In addition, there may be social costs associated withhomeownership, especially for low-income people. Home-ownership often makes it more difficult for people to movefrom one place to another — mobility that might be espe-cially valuable to those in search of better jobs. Renting maymake it easier for them to relocate for a position that moreclosely suits their skills. Also, low-income households havemore difficulty weathering sudden drops in income and largeunexpected expenditures, which could lead to foreclosure.As William Rohe, Shannon Van Zandt, and George McCarthyof the University of North Carolina’s Center for Urban andRegional Studies have noted, “While breaking a lease on arental unit is problematic, the stress and trauma caused bydefaulting on a mortgage is much more serious.”

Overall, then, I think we should be cautious about pur-suing policies that aim to increase homeownership. For somepeople, owning a home is clearly a good decision, which willbenefit them and their neighbors. But for other people, renting may make more sense — again, for both the rentersand society generally. I don’t see a strong reason to tilt theplaying field in favor of one choice or the other, especiallywhen the public benefits and costs of encouraging home-ownership are so uncertain.

NOTEWORTHY

Encouraging Homeownership — at What Cost?

S p r i n g 2 0 0 5 • R e g i o n F o c u s 1

JEFFREY M. LACKERPRESIDENTFEDERAL RESERVE BANK OF RICHMOND

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The Federal Reserve System andits 12 banks owe their existenceto the Federal Reserve Act of

1913. This landmark legislationfamously reflected the model of somany American institutions: to be atonce centralized and decentralized.The Board of Governors sits inWashington, D.C., and formulates U.S.monetary policy in coordination withthe Reserve bank presidents. It’s a system of geographic checks and balances, with the centralized boardrelying on the firsthand regional eco-nomic knowledge of the decentralizedbank chiefs, whose main offices arelocated in cities around the country.And of course, this knowledgeexchange works both ways.

But even divided among 12 Reservebanks, the entire United States is a lotof turf to cover. For this reason, manyReserve banks also keep branchoffices. Since the very beginning, the

role of these branches has been insome debate. At first, branches wereenvisioned as miniature Reservebanks, doing everything the mainoffice could do but on a smaller scale.Then they became more like reposito-ries for specific functions like checkclearing. And the discussion has grownmore complicated in the past decadewith advancing technology and theevolving functions of the FederalReserve System itself.

The Federal Reserve Act statedthat there would be between eight and12 Reserve banks, and cities eagerlyvied for the opportunity to be home toone. But beyond the number ofReserve banks to be created, there wasalso considerable uncertainty over thenature and scope of the banks’ respon-sibilities — an uncertainty compound-ed by the speed with which the bankswere to be established. In addition,confusion arose during the discussionof Reserve bank branch offices. It waseven less clear what powers thesebranches would have, and what rolethey would play within the System.

Twenty-five branch offices wouldeventually emerge, the number varyingfrom district to district, determined bythe needs of the individual Reservebanks. The Fifth District (Richmond),for example, maintains two branches —one in Charlotte, another in Baltimore— while the Sixth District (Atlanta) hasfives branches, and the First and ThirdDistricts (Boston and Philadelphia,respectively) have none. Many districtsalso are home to regional check-processing centers, though the numberof these centers has dropped recently.

Early on, regional branch officeslargely supported the main Reservebanks in an operating capacity, provid-ing functions such as check clearingand cash processing. Over the years,the branches have adapted to theevolving needs of their respective

2 R e g i o n F o c u s • S p r i n g 2 0 0 5

FEDERALRESERVE

New Times, New FunctionsB Y J E N N I F E R W A N G

As the economychanges, so doesthe role of FederalReserve Bankbranch offices

★

NOTE: Districts 1 and 3 don’t have branch offices. SOURCE: Board of Governors of the Federal Reserve System

1-12 Federal Reserve DistrictsBoard of Governors/Washington, D.C.Federal Reserve Bank CitiesFederal Reserve Branch Cities

★


Reserve banks. Some, for instance,have seen their role in the paymentssystem decline sharply, while othershave taken on new responsibilities inthe areas of community affairs andbank supervision and regulation.

Vanishing ChecksThe rapid drop in paper checks is themost urgent factor driving change at thebranches, and has resulted in a sizeablescaling down of infrastructure. Thoughchecks remain the most popular form ofnoncash retail payment, from 1995 to2002 the number of checks written fellby roughly 10 billion. In 2003, the num-ber of electronic payments throughcredit cards, debit cards, and similarinstruments exceeded the number ofcheck payments for the first time — bymore than 8 billion — and the gap isexpected to widen over time.

Major changes at the Fed alsobegan in 2003. A significant Fed initia-tive sought to reduce check serviceoperating costs as the market environ-ment signaled a shift in consumer andbusiness preferences from checks toelectronic payments. The initiativeproposed an annual review of thecheck processing operations networkfor consolidation opportunities; near-by offices would be collapsed into oneanother to take advantage ofeconomies of scale. When the sched-uled office moves are completed nextyear, checks will be processed in 23locations (down from 45), and theoverall check staff will be reduced byabout 400 positions.

In the Fifth District, the Richmondbank closed its check processing cen-ters in Charleston, W.Va., andColumbia, S.C. The checks that hadbeen processed in Charleston weresent to the Cleveland Fed’s Cincinnatibranch, and those processed inColumbia went to Charlotte. In addi-tion, all of the checks processed at themain office in Richmond were movedto the Baltimore branch.

David Beck, vice president andinterim branch manager at theBaltimore office, explains the effect ofthe consolidations. “All of Virginia ter-ritory is now in Baltimore, causing

Baltimore’s check volume to rise ini-tially by 70 to 80 percent,” he says. “Butbecause of an overall decline in volume,that percentage has not held up.”

The Eighth District’s Response Many of the districts faced substantialchallenges when the check restructur-ing process began. But in the EighthDistrict, St. Louis Fed PresidentWilliam Poole described the impact as“seismic.” With its Louisville branchonly 100 miles from Cincinnati, andLittle Rock just 120 miles fromMemphis, it was difficult to justifymaintaining operations at all thebranches. It was ultimately decidedthat operations at the Louisville andLittle Rock branches would be com-pletely shut down and the buildingssold. The staff — reduced to fewerthan 10 employees at each branch —would work in leased space.

These announcements raised ques-tions concerning the necessity of keep-ing the Little Rock and Louisvillebranches at all. But the Eighth Districtdecided that they still served a vital pur-pose. In the St. Louis Fed’s 2003 AnnualReport, President Poole stated that hisdistrict “cannot afford to lose or lessenthe importance of the network of eco-nomic information-gathering resourceswe’ve established, the critical input weget from our branch boards of directorson the regional economy, and the one-on-one relationships we’ve nurturedamong the region’s bankers, teachers,community development agencies, anduniversity professors.”

Indeed, nearly all Reserve bankpresidents cite the vital role of branchoffices in providing up-to-date infor-mation on the state of the economy,which they use in preparing for FederalOpen Market Committee delibera-tions. That information, though oftenanecdotal, can provide valuableinsights about what is happeningaround the districts before formal sta-tistical reports are released.

While Poole and his colleagues relyon the branches to provide them withtimely reports on economic conditions,the branches are trying to increase theirpublic visibility within the communi-

ties they service. According to RandallSumner, vice president of public andcommunity affairs at the St. Louis Fed,“One way of doing that is devotingmore effort to economic education andregional economic research activities.”

Thus far, Sumner believes the transi-tion at the branches has been a smoothone. “This year, we’re going to be takingadvantage of the skills of the new people we’ve hired,” he says. “The proofwill be what it looks like at the end ofthe year. But we’re all very excited andhave every confidence in its success.”

The Fifth District’s Unusual SituationThe Fifth District is relatively uniqueamong Reserve bank districts. Itsbranch offices are located in much larg-er metropolitan areas than its mainoffice. This is one reason why, for now atleast, check-processing will remain aprincipal activity in Baltimore and cashoperations will continue to be signifi-cant in Charlotte. Also, becauseCharlotte is home to some of thenation’s largest financial institutions,banking supervision and regulation hasbecome a crucial function there, as hascommunity outreach.

Beck points out that Baltimore is“one of the largest branches in the sys-tem. And the Baltimore-Washingtonmetropolitan area we serve is certainlya lot bigger than, say, Little Rock or


Electronic Payments HaveIncreased as Check Volume Has Declined

5.5

15.1 30.6 44.5

29.6 49.5 41.9 36.7

19790

10

20

30

40

50

60

70

80

90

1995 2000 2003

Electronic PaymentsPaper Checks

SOURCE: Federal Reserve System

NUM

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ENTS

(INBI

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Louisville. So I think checks andcash operations will remain here fora number of years.”

Jeff Kane, senior vice presidentand head of the Charlotte office,emphasizes the unique status of theCharlotte branch. “I bristle whenpeople talk about branches as gener-ic operations. When you look at thebanking presence in the Carolinas, itfar outweighs anything else outsideof New York.”

In the past, Kane says, “We havethought of our branch as an opera-tional facility. Visitors came in hereand we gave them a tour of thechecks and cash departments, forinstance.” But that’s changing, as theFed seeks to increase its presencewithin the local community.

Many of Charlotte’s big commer-cial banks have important long-stand-ing ties to the region. “There’s not aboard of directors of a nonprofitgroup, charitable organization, or localuniversity that is not touched by thosebanks in a significant way,” Kanenotes. He would like to see theRichmond Fed’s Charlotte office takepart in similar activities. Althoughcareful to point out that he doesn’thave the staff to equal the “visibility ofa commercial banking organizationthat employs 250,000 people,” Kanesays he is working to increase “thepresence of the branch in those circlesin which we operate.”

There are obvious reasons for theexpanded role of the Charlotte officeand of branch offices throughout theFederal Reserve System, Kane says.“What do we all have in common? Theanswer is we are all tied to the localeconomy and to the prosperity of theregion, and because of that it makessense for the branches to increase ourcommunity outreach activities.”

A New LegOne of the most popular metaphorsfor the Fed is the image of a stool, withthree legs representing each of thethree main areas traditionally underthe Fed’s jurisdiction. There is a mon-etary policy and research leg, a bank-ing supervision and regulation leg, anda financial services and paymentsmechanism leg. Recent and forthcom-ing efforts to increase the Fed’s com-munity outreach activities, though,may lead to the addition of a fourth leg— a type of public education/commu-nity outreach leg.

Jeff Lacker, president of theRichmond Fed, says, “If you look atwhere our head office is and where ourbranches are across the district, it’sclear that the branches have an impor-tant role to play in connecting us to ourdistrict.” Besides plans to improve eco-nomic education and financial literacyprograms in the region, efforts toexpand regional economic research alsowill be strengthened. “We’ve alwaysmonitored regional economic condi-tions out of our head office. But you canonly do so much of it from Richmond.

We have a very diverse region, and it’simportant to be aware of those differ-ences. So we’re looking to hire region-al economists to put into those officeswho would be able to focus on theregion around the branch.” Addition-ally, Lacker envisions hosting events incities throughout the district. “That’san area where I think the branches canplay a role. They have a presence intheir regions, and we can use them toreach out to the communities.”

Banking is an area in which the Fedtakes a keen interest, of course, andthe freeing up of resources oncedevoted to payment systems opera-tions may help the Fed build and sus-tain stronger relationships with pri-

vate banks through its regional offices.“We’ve generally tried to maintain arelationship with banks that goesbeyond our supervisory function,which encourages them to feel as ifthey can communicate with us aboutany banking issue that’s of concern tothem,” Lacker says. “Even if we can’tpass a law for them, we want them tofeel as if we understand what’s going onin their industry. We’re going to belooking for ways to foster that dialoguewith the banking industry.”

The functions of Reserve bankbranch offices have recently under-gone significant changes. But theirpurpose has, in one sense, remainedthe same: to assist the main office incarrying out its aims and objectives.

Lacker concludes, “If you look atthe System from the point of view ofthe way it was designed in 1913 — as 12banks as opposed to one big bank —it’s clear Congress meant us to be verywell connected to our districts. Weneed to really know what’s going onand to be responsive, and the brancheshave an important role to play in help-ing us achieve that goal.” RF


Greene, Stephen. “Branching Out: The St. Louis Fed’s ThreeBranches Extend Beyond Bricks and Mortar.” In the FederalReserve Bank of St. Louis 2003 Annual Report, pp. 6-20.

Hammes, David. “Locating Federal Reserve Districts andHeadquarter Cities.” The Region, September 2001, vol. 15, no. 3, pp. 24-27 and 55-65.

Harless, Doris E. “The Federal Reserve Bank of Richmond: ABrief History.” Cross Sections, Fall 1989, vol. 6, no. 3, pp. 8-9.

Visit www.richmondfed.org for links to relevant sites andsupplemental information.

R E A D I N G S

“Reserve bank presidents cite the vitalrole of branch offices

in providing up-to-dateinformation on the

state of the economy,which they use in

preparing for FOMCdeliberations.”


While other sports teams demand that taxpayers fundnew stadiums, the Richmond Braves have offeredto build their own ballpark as part of a $330 million

development. The catch is the minor-league baseball club wantsto use tax increment financing (TIF) to cover the stadium’s$80 million cost. Cities and counties throughout the FifthDistrict use this mechanism, but TIF isn’t the free lunch thatits supporters portray it to be.

California pioneered TIF in 1952 and a few states followed.The mechanism became more widely used in the 1970s and’80s. West Virginia and North Carolina were among the laststates to embrace TIF, with voters approving this approach in2002 and 2004, respectively.

Here’s how it works. Municipalitiesissue debt to pay for public improve-ments. The debt is repaid using just therevenue generated by increases in prop-erty values, retail sales, or other taxableactivities within a designated area thatbenefits from the improvements.Typically, a separate developmentauthority issues the debt in the form oftax-exempt bonds.

TIF’s main selling point is thatlocalities can encourage private invest-ment in economically distressed orblighted areas without dipping intotheir budgets directly. They also avoidissuing general obligation bonds,which requires public approval.(Charlotte voters, for example, soundly rejected a bond issueto pay for a new basketball arena and minor-league ballpark in2001.) Such bonds also count against a locality’s debt limits.

Studies have shown that TIF can have positive effects onproperty values of designated areas, but that growth maycome at the expense of other places. “When you build a TIF[project], it drains development out of the rest of the city,”says economist David Merriman of Loyola UniversityChicago, who co-authored a 1999 paper on how TIF hasaffected growth patterns in the greater Chicago area.

Of course, redistributing wealth to blighted communitiesmay be the goal of TIF users. Several states, for instance, havea “but-for” test that requires TIF to be used for publicimprovements in a location only if private developmentwouldn’t have take place there. But proving such a thing isoften difficult to do, says Merriman and others.

This highlights an important risk. Bond investors must beassured that they will receive their payments, or few TIF-backed projects will go forward. Since repayment of TIF

bonds depends on development occurring where it supposed-ly would not have happened, this uncertainty could scare offinvestors. South Carolina had this problem until municipali-ties were allowed to offer water and sewer revenues as a backup source of debt payments.

A locality also can promise to appropriate general funds ifincremental revenue from a TIF-designated area falls short.“It’s not a binding obligation,” but a good faith provision, says John Petersen of George Mason University’sSchool of Public Policy. Still, a locality is unlikely to let a TIFbond default because doing so could hurt its credit rating.

This arrangement exists in Richmond, where streetscapework on Broad Street and the construction of downtown

parking garages are being funded withTIF. If the taxing district yields alower amount of parking fees andother revenue than what is necessaryto cover the bond payments, the cityhas promised to pay up to $3 million ofthe shortfall.

To minimize these risks and makeTIF more attractive to investors, localofficials may ask for a letter of creditfrom the developer or keep the pro-ceeds of a TIF in escrow until a projectmeets certain milestones. More com-monly, they wait until economicgrowth is already occurring in an areabefore approving the use of TIF, orthey recapture revenues from a

broadly drawn taxing district that includes nearby businesses. These latter tactics contradict the idea that TIF should

support development that wouldn’t have occurred otherwise.In West Virginia, TIF has been used mostly in areas where thepopulation is growing, not in counties that have been losingresidents and lacking economic development.

Even when new development occurs as planned, TIF oftenstill represents an opportunity cost to taxpayers. The incre-mental increases in tax revenue that would have gone to a vari-ety of general purposes instead go toward repaying debt for 20years or more. Further, that revenue is unavailable to fundservices needed by new businesses or residents.

Despite these costs and risks, communities may still bewilling to leverage tomorrow’s tax revenues in order to influ-ence the pace and nature of development today. “The com-munity can go to the developer and say, ‘We can provide a lotof your basic financing at a cheaper rate … but here’s thekind of project we want,’” says Petersen. For developers,that’s a difficult offer to refuse. RF

POLICY UPDATE

Betting on the Future to Finance the PresentB Y C H A R L E S G E R E N A


TIF Projects In ActionDistrict of Columbia: Mandarin Oriental Hotel,Gallery Place (mixed-use development)Maryland: Toys-R-Us distribution center inFrederick County; Park Place in Annapolis(mixed-use)South Carolina: Sewer and road improvementsin Hilton Head; Manchester Village in Rock Hill(mixed-use)Virginia: MacArthur Center in Norfolk (regionalmall); Town Center of Virginia Beach (mixed-use)West Virginia: Extension of sewer lines in grow-ing residential areas in Raleigh County; Square atFalling Run in Morgantown (mixed-use)


E conomic life is often compared to a game. In manyways, this is an accurate characterization. Participantsin the economy try to maximize their outcomes with-

in a rule-based structure, much as players of a game do. Assuch, some economic actors are very successful, while othersappear to get left in the dust.

At one time or another, most people suffer some sort ofeconomic setback. People may invest their money poorly,lose their jobs, or find that their skills and knowledge havebecome obsolete. The high visibility of these negative out-comes has led some pundits, and a few economists, to arguethat the economy functions as a zero-sum game.

Just what is a zero-sum game? Mathematically, a zero-sumgame is one in which the sum of all the gains and losses madeby all the players must be zero. This is the familiar idea thatone man’s loss is another man’s gain. Forexample, poker is a classic zero-sumgame. At the end of the night, thetotal amount of money involved inthe game is the same as at the startof the game. Thus, any money madeby one player must come at theexpense of the others.

Is it fair to argue that a marketeconomy works the same way as a zero-sum game? Must every economic actionhave losses as big as the gains? No.

The first flaw in the zero-sumargument is the implicit assumptionthat a fixed basket of goods has thesame value to all people. But the samegood may have different utilities for different people. Forexample, I might not value a designer dress at all since I haveno use for it, but my sister might highly value the dress.Thus, with a fixed array of goods, different combinations ofthose goods will lead to different overall levels of utility.

More important, the total amount of wealth in the worldis not fixed. Consider the example of Henry Ford and theautomobile. In 1908, Ford introduced the Model T, the firstmass-produced and widely affordable car in history. Throughhis innovative use of assembly lines, Ford was able to pro-duce reliable cars at relatively low cost. By 1927 he had sold15 million cars, his company employed well over 100,000workers at wages double industry standards, and almost7,000 Ford dealerships had been opened across the country.

Needless to say, Ford himself became extremelywealthy in the process. However, Ford also greatlyincreased the wealth of countless others through his inno-vations. He provided high-paying jobs to thousands of

workers while producing a much-valued new good to theburgeoning middle class.

The Ford example demonstrates that the level of wealthin a society is not fixed. Though the supply of some rawmaterials is limited, technological improvements are constantly increasing the productivity, distribution, andquality of the goods produced from these materials. Thesechanges make virtually everyone better off. Thus, mosteconomic activity cannot be called zero-sum games.

Still, it is possible for some people to suffer losses. Forexample, many manufacturing jobs have moved fromwealthy countries such as the United States to developingcountries, leaving many U.S. workers without jobs, at leasttemporarily. The economic hardships that result from globalization are real, and there is justifiable interest in

implementing public policies that will better prepare American workers to

succeed in a changed environment.But we also must remember that

globalization increases the efficiencyof the world economy by allocatingresources to their maximum effect. Infact, trade is a perfect example of whatis known as a positive-sum game.Some jobs are lost in the process, butoverall those losses are more than off-set in the long run by cheaper goodsand the movement of capital intomore competitive projects. It’s useful to consider the Ford exam-

ple again in this context. The introductionof the Model T surely harmed other auto manufacturers thatwere unable to compete with Ford’s new product. But manymillions of people were benefited in the process, making it apositive-sum game.

Are there also examples of negative-sum games? Yes.Certain government regulations, for instance, can producesuch outcomes. Consider Manhattan’s housing market. Thecity of New York imposes rent controls on some apartments,which cap the rents that landlords are allowed to charge ten-ants. This regulation provides a disincentive to maintain theexisting housing stock or to add to it. The result is a nega-tive-sum game. Those who can secure a rent-controlledapartment are made better off. But the majority of NewYorkers wind up paying higher rents because there is notenough supply to meet demand.

It’s important to remember that this example is unique.Zero-sum games can occur, but they are unusual and often theresult of public intervention into private markets. RF


JARGONALERT

Zero-Sum GameB Y E R I C N I E L S E N

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Since Sept. 11, 2001, terrorism has been firmly planted in the public’s mind. While much of the policy debatehas focused on measures that might help prevent

future attacks, some economists have turned to analyzingthe factors that breed such risks in the first place.

Much of that work has concluded that poverty is a corecause of terrorism. But Alberto Abadie, an economist atHarvard University, argues that there are other, more impor-tant factors, including a country’s level of political freedom,its degree of linguistic diversity, and its natural terrain orgeography.

Previous studies on terrorism also make a crucial mistake byexclusively considering international acts of terrorism, arguesAbadie, a native of Spain’s Basque region, which is home to astrong separatist movement that wants political independencefrom Madrid. These studies use statistics provided by the U.S.State Department, which include only those terrorist acts thatinvolve citizens and property ofmultiple countries.

A significant number of terrorist attacks, however, arecarried out domestically —involving citizens and propertyof a single country. Abadie notesthat in 2003 alone, there were1,536 accounts of domestic terrorism compared to 240international accounts.

Abadie uses data from the World Market ResearchCenter’s Global Terrorism Index to estimate the risk of terrorism. These forecasting data consider the risk of attackagainst 186 countries around the world and their respectiveinterests abroad, such as embassies.

So what factors increase the risk of terrorist attacks? As noted above, many economists have argued that wealth— or, more precisely, lack of it — may be a principal factor.Wealthy countries may be widely resented by people frompoorer countries, and thus become terrorist targets. Thismay be especially true when the rich country is seen asengaging in “economic imperialism” by exporting its goodsand culture to less prosperous parts of the world.

Also, poverty may create an environment where people,unhappy with their own lots in life, turn to violence at home.For instance, a number of studies have documented thatpoverty increases political strife, which can lead to civil war.

Abadie finds that countries with lower incomes do infact have higher terrorist risks. While these results mayseem to lend some credibility to the idea that povertybreeds terrorism, the situation is more complicated.

Lower-income countries have higher terrorist risks notbecause they are poor but because they generally have addi-tional characteristics that fuel terrorist activity, Abadiesays. In other words, there is no causal link between pover-ty and greater terrorist risk.

The level of political freedom in a country, for instance, is an important factor in determining how much risk a coun-try may face. How does this process work? “Over most of therange of the political rights index, lower levels of politicalrights are associated with higher levels of terrorism,” Abadiewrites. But this is untrue of highly authoritarian countries.The policies those countries adopt to stifle political dissentmay help keep terrorism at bay, Abadie argues.

Thus, both free societies as well as authoritarian ones tendto be at less risk than those in the middle — countries withmoderate levels of political freedom. Those risks may be especially acute for countries like Russia and Iraq, which are

making the transition fromauthoritarian political systemsto more democratic ones.

Internal strife caused by ethnic or religious differencesalso may elevate the risk of terrorism, some analysts haveargued. But the real key is notethnicity per se, but the num-ber of languages spoken in acountry, Abadie says. The high-

er the probability that two people from a given country speakdifferent languages, the higher the country’s terrorist risk.

Geographic factors also are important. Three key variablesincrease a country’s risk: size, elevation, and the fraction of thecountry that is tropical. Certain features, such as mountains orrain forest, provide potential terrorists with relatively safetraining grounds. Geographic characteristics also contribute tothe production of illegal drugs, which are sold to finance terrorist activity. For example, terrorists in Afghanistan havesold opium for funding and relied on mountains for protection,while those in Colombia have used cocaine and the rain forest.Lastly, larger countries may have more trouble monitoringpotential terrorists, increasing the terror risk.

Abadie’s work suggests that there is no magic cure for the root causes of terrorism. Increasing political freedom in a country is a long and difficult process, and there are no obvious policy responses to the problems raised by linguisticdifferences and geographic characteristics. Still, his research may help us determine the places where terrorist activity is most likely to arise and to better focus our efforts in preventing future attacks. RF

RESEARCHSPOTLIGHT

An Economist Considers the Causes of TerrorismB Y A N D R E W F O E R S T E R


“Poverty, Political Freedom, and the

Roots of Terrorism” by Alberto Abadie.

National Bureau of Economic Research

Working Paper 10859. October 2004.


BEAN BALL

The Designated Hitterand Moral Hazard

Batters in the American League(AL) of Major League Baseball

have long faced the unpleasantknowledge that they are 15 per-cent more likely to be hit by apitch than their National League(NL) counterparts.

A virtual cottage industry hassprouted to explain the AL’s rate ofhit batsmen. The most acceptedconclusion is that the introduc-tion of the designated hitter (DH)in the AL in 1973 created a moralhazard problem. That is, pitchersin the NL face a higher price forplunking batters because they, as batters themselves, canface retaliation for their errant pitches. Meanwhile, in theAL, pitchers almost never step into the batter’s box, sincedesignated hitters take their place at the plate. The conse-quences of a brush-back pitch are far less severe in the ALthan in the NL.

Another theory posits that NL pitchers go out of theirway not to hit their pitching counterparts because they’resuch awful swingers; hitting a pitcher is a waste because it’sso easy to get them out, statistically speaking.

A recent contribution to the literature comes from JohnCharles Bradbury and Douglas Drinen, professors atSewanee: The University of the South.

Overall, they agree that much of the difference betweenthe two leagues is attributable to AL pitchers’ lack of fear ofretaliation. But Bradbury and Drinen plow deeper than anyothers have ventured: They attempt an explanation for thenarrowing hit-batsmen gap during the 1990s — when, coun-terintuitively, in four years there were more batters sent divingfor the turf in the NL than the AL. Their answer is twofold.

First, league expansion diluted the talent level in the NLmore than in the AL, which probably meant that more bat-ters were unintentionally hit by wild, inexperienced pitch-ers. Second, there was the 1994 establishment of the “dou-ble-warning” rule, requiring umpires to warn both teams ofconsequences after an obvious bean ball or attempt. Thatmatters because it “significantly raises the cost of retalia-tion. If a pitcher hits a batter, he knows that retaliation willbe very costly for the other team.” Thus, NL pitchers havelet themselves get a little wilder since 1994.

And maybe now, for a few years at least, baseball wonks can sleep soundly at night, content in the knowl-

edge that the mystery of the hit-batsmen differential has beenexplained. — DOUG CAMPBELL

LAND OF THE ECONOMICALLY FREE

Virginia Ranks Third inNew Study

A ccording to a new studyreleased by the Pacific

Research Institute (PRI), a market-oriented think tank based in SanFrancisco, Virginia stands as a“citadel of economic freedom inthe South.” The 2004 U.S. EconomicFreedom Index ranks Virginia as thethird most economically free statein the United States. No otherFifth District state placed in the

top 10: South Carolina (13), North Carolina (24), Maryland(27), and West Virginia (32).

Sally Pipes, president and CEO of PRI, describes theEconomic Freedom Index as an “important tool, grounded in rig-orous statistical analysis, for measuring how friendly (orunfriendly) each state government is toward free enterpriseand consumer choice.” PRI’s study of individual states ismodeled loosely after existing research conducted on aninternational scale, such as the Economic Freedom of the Worldand the Economic Freedom of North America reports, publishedby the Fraser Institute and others.

To calculate index values, more than 140 variables wereconsidered for each state, including everything from tax rates,state spending, and income redistribution, to occupationallicensing, environmental regulations, and wage laws.Ultimately, a statistical index linked to migration was adoptedto rank states in terms of economic freedom, because, thereport explains, “migration is the purest expression of individ-uals responding to differences in freedom … People want to befree: they strive and work to be free, and search out locations,governments, and situations where freedom reigns.”

The study’s authors, Lawrence J. McQuillan, director ofBusiness and Economic Studies at PRI, and Robert E.McCormick and Ying Huang of Clemson University’s eco-nomics department, hope that the new Index will persuadepeople that there is a link between economic freedom andeconomic prosperity. As McQuillan says, “It affects theirbottom line, their pocketbooks — and it’s an appropriateissue for policymakers to focus on.”

According to the report, “a 10 percent improvement in astate’s economic freedom score yields, on average, about ahalf percent increase in annual income per capita.” Or, to


SHORTTAKES

Sammy Sosa of the Chicago Cubs recoils as a fastballshatters his helmet in 2003. Sosa now plays for theBaltimore Orioles.

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put it another way, the average national “oppression tax” peryear is 4.42 percent of an individual’s income, and the aver-age money amount lost from restrictions on economic free-dom per year is $1,161 — adding up to almost $90,000 overa 40-year working life.

Still, the Index’s findings reveal several surprises. Kansas,a relatively low-profile state, secured the top spot, whileCalifornia and New York — states renowned for being hubsof commerce and activity — trailed at the rear, in 49th and50th place, respectively. These results seem to suggest thatwhile economic freedom is important, it is not the only —or even the most significant aspect — in determining thesuccess of a state’s economy. — JENNIFER WANG

FACT OR FICTION?

Looking for the Social Security Trust Fund

News flash: Not only does the much-talked-about“Social Security trust fund” exist, it is physically locat-

ed in the Fifth District. But it’s not in Washington, D.C., asyou might suppose. It’s in West Virginia.

A spokesman at the U.S. Bureau of the Public Debtsounds a bit weary talking about it. Ever since PresidentGeorge Bush made reforming Social Security a centerpieceof his second-term agenda, there’s been a surge in interestabout the fund. Media calls have been incessant.

The Bureau of the Public Debt is the government armthat actually does the work of investing tax receipts, issuingsecurities, and redeeming those securities at the request ofthe Social Security Administration. And all that happens inthe bureau’s operations center in Parkersburg, W.Va.

To call it a “fund” is a bit misleading, the spokesmanadmits. It consists of 215 sheets of paper representing secu-rities held by the Old Age and Survivors Insurance andDisability Insurance funds. This winter, those paper instru-ments together symbolized $1.7 trillion in securities issuedto the trust fund. As such, they’re not really the sort of cashholdings you might intuitively think of when hearing aboutthe Social Security trust fund. They’re IOUs, but given thatthey’re backed by the federal government, many peopleclaim they’re pretty much as good as real money.

The trust fund’s paper certificates are locked in a fire-proof safe — which looks more like a filing cabinet than asafe — in the Bureau of the Public Debt’s operations centerat the H.J. Hintgen Building in Parkersburg. Not that thesafe gets a whole lot of attention. It sits outside somebody’soffice. The papers themselves are merely outputs from astandard office laser printer, signed by the division directorfor federal investments.

The reason the 215 pieces of paper exist is because of1994 legislation that established the Social SecurityAdministration as an independent agency. The law requiredthe Treasury Department, which runs the Bureau of thePublic Debt, to issue paper instruments to represent thetrust fund’s assets.

In the debate over overhauling Social Security, the significance of the fund has gained new importance. Officialprojections say that by 2017, the government will have tostart tapping into the fund to fulfill its payment obligationsto retirees. By 2041, the funds will have been used up. And presumably, the safe in Parkersburg will no longer contain those pieces of paper now ostensibly worth trillionsof dollars. — DOUG CAMPBELL

ONLINE BANKING

Customer Satisfaction Rises, But PrivacyConcerns Remain

Who would have thought 10 years ago that paying billsand monitoring account balances would be only a

mouse-click away? It’s taken a while, but more and morebanking customers have moved from standing in line at thebank to doing business online in their home.

Forbes.com and the consulting firm ForeSee Resultsrecently teamed up to release their second online bankingstudy. They wanted to find out how comfortable customersare in conducting transactions online, and how banks mightbe able to increase the size of this market.

Overall, the report showed an increase in customer satis-faction, with a rise of 5.5 percent since the previous summer2003 study. This is important because, according to thestudy, “satisfied” online customers are almost 40 percentmore likely to purchase additional services. The rise in satis-faction might be attributable in part to effective marketing.

In general, customers are happier because online bank-ing is becoming easier. The site needs to be relatively pain-less to navigate in order for customers to easily set up billpayment options, for instance. The reward for banks thatcreate such sites is that satisfied customers tend to feel more“loyal” toward them. Also, online banking sites are oftencheaper to maintain than traditional bricks-and-mortarbanking establishments.

Though customer satisfaction has risen since the firststudy two years ago, certain challenges remain. Some sitesremain stubbornly user-unfriendly. Privacy also remains abig obstacle with potential online bankers, who worry aboutthe security of their personal information. Existing cus-tomers, however, feel comfortable with how banks manageconfidential information. Improved education of the publicon these concerns may help, the study says. In addition,banks must compete with other third-party payment outletsfor the business of more savvy online consumers. Three-quarters of respondents reported paying bills online througha source other than their own bank.

In the end, the greatest challenge facing banks is to getmore potential customers online, and then keep them there.Those people who feel comfortable doing business on theInternet have generally availed themselves of online bankingopportunities. But this group makes up only 25 percent of allbanking customers. That leaves a huge untapped market forbanks to serve. — JULIA R. TAYLOR



Washington, D.C., radio sta-tions reach far beyond theborders of the nation’s

capital. Their traffic reports providevital guidance to drivers commutingfrom the outskirts of the metro area,from Charles County in southernMaryland (28 miles from downtownWashington), to Fredericksburg in central Virginia (52 miles away), toJefferson County in the EasternPanhandle of West Virginia (73 miles).

Most Washington workers live out-side of the city, driving half an hour, onaverage, each way. Other suburbanitesand rural residents throughout theFifth District are well acquainted withinterstate travel, working in one placeand living somewhere else miles awayin order to earn a better salary, benefitfrom a lower cost of living, or both. Inthe U.S. Census Bureau’s 2003 popula-tion survey, about 2.6 million of the 40million people who relocated did itbecause they were looking for acheaper place to live.

There certainly isn’t a lack of resi-dential development — housing con-struction has been rising for years inboth metro and nonmetro areas. Theproblem is the type of developmentthat has occurred in certain housingmarkets. These markets emphasizelarger, pricier homes for purchaseover smaller homes and multifamilyrental units that are less expensive tobuild and sell.

“In most places, the new construc-tion is going for the high end of themarket,” says C. Theodore Koebel,director of the Center for HousingResearch at Virginia Tech. “We’re notbuilding for the middle of the market,and we’re certainly not building any-thing for below the middle.” As aresult, people at or near the median


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boundHousing markets work just fine for most people.

But certain markets in the Fifth District aren’t producing

homes and apartments that working families can afford

B Y C H A R L E S G E R E N A


income cannot afford the median-priced home or apartment in a growingnumber of communities, while thosefurther down the income scale are feel-ing the squeeze even more. “Homeprices have moved closer to the median,whereas their incomes have not movedup toward the median,” adds Koebel. “Ifanything, they have moved further awayfrom the median.”

Housing affordability has long beenan issue for the poor and those onfixed incomes. People at the bottomare the least able to respond to priceincreases or relocate, and they have sofew financial resources that it’s hard tobuild shelter cheap enough for them toafford. Now, mounting housing costsare outrunning the earnings of work-ing families as well, taking bigger bitesfrom the paychecks of retail storeemployees, teachers, nurses, and otherlow- to moderate-income workers.Not adjusting for inflation, data fromthe Office of Federal HousingEnterprise Oversight and the NationalAssociation of Home Builders showsthat house prices appreciated 78 per-cent from 1994 to 2004. National personal income increased only 64percent during the same period.

In other words, affordable housingis a concern for wider segments of the U.S. population. The number ofmiddle-income families devoting more than 30 percent of their incometo housing grew from 3.2 million in1997 to 4.5 million in 2001. This 41 per-cent increase exceeds the populationgrowth in this income group.

What is behind the growing dividebetween what people can pay andwhat housing sells for? The leadingcandidate on the supply side of themarket equation is the collision ofrapid population growth with con-strained residential development inregions like Northern Virginia. “Theregion is pretty heavily regulated interms of land use, and that’s true of theWashington metropolitan area in gen-eral,” says Richard Green, director ofGeorge Washington University’sCenter for Real Estate and UrbanAnalysis. “When you have limits onsupply, it means that increases in

demand will show up in prices ratherthan in quantity.”

Opening the door to more develop-ment wouldn’t necessarily provideaffordable options for all — it doesn’taddress demand-side factors that puthousing outside of people’s grasp —but it might reduce the number ofpeople in need. Then, governmentagencies and nonprofit organizationscould tackle housing affordability in amore targeted manner.

Where’s the Problem?When reporters and researchersexamine housing affordability in acommunity, they often refer to theshare of income that residents spendon putting a roof over their heads. TheU.S. Department of Housing andUrban Development (HUD) considersan apartment or home to be unafford-able when expenses like rent, mort-gage payments, and property taxesexceed 30 percent of earnings, sincethat leaves an inadequate amount ofmoney to pay for other necessities likefood, clothing, and health care.

For example, the median annualsalary of a kindergarten teacher in theWashington, D.C., metro region is$48,396, according to surveys con-ducted by Salary.com. Thirty percentof that income would be $14,519, or$1,210 a month. Thus, teachers earningat the median could qualify for a$155,000 house, assuming they can geta 30-year loan at a 5.75 percent fixedinterest rate and put down 10 percentof the price toward the down paymentand closing costs. However, the D.C.region’s median home price was$340,000 in the fourth quarter of2004, and it hasn’t been near the$155,000 mark since 1998.

Using income-cost ratios to gauge aneighborhood’s housing affordabilitydoesn’t take into account individualpreferences, though. “Some house-holds may consider their housing agood deal even if they spend morethan 30 percent of their income on it,”noted Ron Feldman, an assistant vicepresident at the Federal Reserve Bankof Minneapolis, in an August 2002working paper. “[They] may prefer to

live in amenity-rich locations, withnice weather, for example. In suchlocations, the greater demand forhousing would boost its cost.”

Moreover, low-income people maymake short-term sacrifices in theirbudgets so that their children cangrow up in safer neighborhoods withbetter schools. Others, especiallyyoung people, may initially toleratehigh housing costs relative to incomeif they expect their incomes to riseover their lifetimes. Economists saythat such smoothing of consumptionis common — people plan their pres-ent consumption based upon whatthey observe today and what theyexpect for the future.

Using income-cost ratios also doesn’ttake into account the availability ofcredit. That’s why Howard Savage, aresearcher at the Housing andHousehold Economic StatisticsDivision of the U.S. Census Bureau,includes household assets in hisreports on home affordability. “If they had to, people could sell some oftheir financial assets to buy a house,”he says, or they can borrow againstthem. Therefore, when the cost ofcredit is cheaper, “people can afford topay more. When interest rates gethigher, which they will someday, theywill be able to pay less than what theycan now.”

No matter how it is measured,housing affordability isn’t a problemconfined to notoriously expensivecities like New York or San Francisco.“People with critical housing needs[those who pay more than 50 percentof income on shelter] are more likelyto be found in the Northeast and theWest, but it’s a growing problem in theSouth and the Midwest,” notesBarbara Lipman, research director atthe Center for Housing Policy inWashington, D.C.

Affordability can become an issuein any community where economicprosperity and residential develop-ment aren’t in sync. For example, partsof the Baltimore region have done welleconomically, but housing develop-ment hasn’t occurred in the sameplaces, according to John Kortecamp,



executive vice president and CEO ofthe Home Builders Association ofMaryland. “The demand is not beingmet where the jobs are being created.”

The city has thousands of vacanthomes that could be redeveloped ortorn down to make room for afford-able housing. Yet crime and under-performing schools have resulted inpopulation losses in these deterior-ating neighborhoods, leaving behindlower-income residents who don’tearn enough to pay even the mostmodest housing costs.

Meanwhile, smaller homes and multi-family units aren’t being built outsideof the city, where higher-income peo-ple have moved, because of communitypressure to reduce density. As a result,“Every time a new project opens up,the prices get bid up substantially,” saysKortecamp. Waterfront communitieslike Fells Point and Locust Point arebeing redeveloped for high-end buyersto take advantage of unmet marketdemand.

The Charlotte, N.C., metro areahas experienced broader economic and residential development thanBaltimore has. John Byers, president of

the Charlotte Regional RealtorAssociation, describes a flurry of new housing in the city’s downtown,especially condominiums, and redevel-opment of older neighborhoods neardowntown in response to the influx ofnew residents.

This rising demand has driven upprices. “If you are looking for the mostbang for your buck, you may not livedowntown,” notes Byers. But moreaffordable options are available withina short drive from Charlotte’s employ-ment centers. He knows of severalbuilders producing smaller, simplerhomes for working families.

On the opposite end of the afford-able housing spectrum is Washington,D.C. The metro region’s economicgrowth has been strong, but the costof residential development is so highin Virginia counties like Loudoun andFairfax and Maryland counties likeCharles and Calvert that only expen-sive projects go forward. The result ispeople driving an hour or more toWest Virginia or central Virginia tofind more affordable options.

The Supply Side: What SellersCan Build What has driven up the cost of residential development in thesecounties and in other communities,pushing housing costs beyond thefinancial means of some working-class families? Joseph Gyourko, a professor of real estate and finance at the University of Pennsylvania,believes that land is the culprit.“Construction costs have gone downover the last 20 years,” while landcosts have climbed in certain places.

One would expect that in areaswith strong demand for housing, the marginal cost of acquiring land for development would increase asavailable space becomes scarcer. Inrecent papers, Gyourko and econo-mist Edward Glaeser at HarvardUniversity have argued that man-made scarcity — namely zoning rules,building codes and other regulatoryconstraints on residential develop-ment — is a bigger factor.

“If demand is going up in areas

where you have restricted the abilityto develop, you’re going to get veryhigh land prices,” explains Gyourko.This makes it harder to build lessexpensive housing. “[Builders anddevelopers] want to spread the fixedcosts of those restrictions over a bigger base, so [markets] end up tiltingtoward a higher-value product.”

Although most methods of regulat-ing residential development add tohousing prices, they have been utilizedsince the early 20th century to meetlegitimate policy goals. For example,the outcry over poor families living incrowded, substandard tenementsprompted lawmakers in New York andother cities to require that residentialbuildings have larger rooms, indoorplumbing, external windows, and separate hallways.

“The market would create someserious problems without some levelof land-use planning,” argues VirginiaTech’s Theodore Koebel. “You mightnot have efficient use of certain locations.”

Regulation of residential develop-ment also stems from a community’sdesire to discourage the construction ofsmaller homes, multifamily rental prop-erties, and manufactured housing likemobile homes. Neighbors fear thatthese less expensive options will lowerproperty values, even though numerousstudies have cast doubt on this claim.

For instance, Charles Countychanged its land-use regulations in the late 1990s and early 2000s toaddress concerns over the type ofhousing being built to meet demand,according to the county’s communitydevelopment housing plan drafted in 2004. Officials increased the minimum size of townhouses and single-family, detached homes to 1,650 square feet, and imposed architectural standards such as requiring the use of brick exteriors.“The idea was to ‘upscale’ the housingstyles,” says Robert Tourigny, housing division administrator of an anti-poverty group called theSouthern Maryland Tri-CountyCommunity Action Committee(SMTCAC). In the process, the new


Moving UpIn southern Maryland, there isn’t a large supply ofolder housing stock to redevelop into affordablehomes. More than half of the region’s owner-occupied units were built in the last two decades in response to population growth.

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rules also upped development costs.Communities also oppose dense

development out of concern forcrowded roadways and schools. Once acommunity is built out with relativelysparse, single-family development, it isdifficult to rezone it to meet risingdemand. SMTCAC lobbied CalvertCounty officials to change the zoningin its town centers to allow mixed-usedevelopment with housing abovestorefronts. “The county commission-ers looked at us like we had two headsand were from Mars,” says Tourigny.

With no land available to meetdemand, development often spillsinto neighboring communities.“Those areas get hit with a lot ofmajor development all of a suddenand are completely unprepared for it,”notes Koebel. In turn, local officialsmay impose their own land-userestrictions.

This scenario has played out in the

Washington, D.C., area — restrictionsin Fairfax County pushed demandwestward to Loudoun County, whichimplemented slow-growth measures in1999 that pushed development fartherwest into Jefferson County, W.Va. (InMarch, the Virginia Supreme Courtoverturned Loudoun’s slow-growthregulations, much to the satisfactionof the numerous property owners anddevelopers who had protested themeasures.)

Regardless of the motives, “land-use planning has to reasonably antici-pate what future growth is going to be,and plan for that growth,” says Koebel.When it leaves a lot of demand forhousing unmet, prices can skyrocketand affordable options can evaporate.

The Demand Side: What BuyersCan PayOf course, supply-side factors aren’talone responsible for driving up the

cost of residential development. Thingsalso have been happening on thedemand side. As long as some buyersand renters in a community are willingand able to pay higher prices, the mar-ket as a whole will bear those prices,even if some people can’t.

Often, newcomers that aren’t eco-nomically tied to a community distorthousing prices. For example, workersfrom flourishing suburbs may migrateto urban and rural communities wheretheir incomes are relatively high andthe cost of living is relatively low so theycan get the amenities they want. As aresult, housing prices will rise, sincenewcomers will still consider them rela-tive bargains. Meanwhile, many nativesmay be unable to keep up with risingprices and property taxes because thereare few job opportunities around.

Back in southern Maryland, popu-lation growth has come from workersmigrating from the District and


Enlarging the ranks of homeowners has been viewed as a way tobring stability to the finances of communities and individuals. Atthe same time, though, the push toward homeownership may becontributing to affordability problems in various housing markets.

First, the mortgage interest deduction and the exclusion ofhome price appreciation from capital gains taxes are only availableto those who earn enough income to itemize deductions on theirtax returns. Moreover, both tax breaks increase with the size of thehouse. Therefore, the people who benefit the most have higherincomes and own larger homes, thus orientating housing marketsaway from lower-income buyers looking for smaller properties.

Second, local officials and communities usually view con-verting multifamily rental units into for-sale condominiums orreplacing them with single-family homes as supporting entry-level homeownership and higher property values. But conver-sions also reduce the supply of rental units. This helps apart-ment markets avoid a period of oversupply that requires ownersto reduce their rents to attract tenants, which is good for apart-ment owners and developers. It’s not so good for tenantsbecause they never see prices fall and they are left with feweraffordable options.

So what if there is less rental housing available? In general,homeownership may not be appropriate for everyone. “Withmortgage delinquencies and foreclosures at record levels … mil-lions of poor families might have been better off today had theynot chosen to purchase a home,” noted an article in theJanuary/February 2003 issue of Shelterforce, a publication of the

National Housing Institute. “Lower-income families are morelikely to borrow against the equity in their home, often at highrates, diminishing any accumulated wealth.” And, they are morevulnerable to downturns in the real estate market since more oftheir wealth is tied up in their homes.

At one time, renting an apartment was something young cou-ples did while saving money to buy a house or to avoid dealingwith the overhead of homeownership. Now, there is a bias againstrenters. They are perceived as people with financial difficultieswho could bring trouble. As a result, communities often opposethe approval of rental housing.

Meanwhile, developers seem less interested in serving renterson the low end of the income scale. For example, GumenickProperties decided that three of its rental properties in HenricoCounty, Va., were “worn out” and “nearing the end of its usefuleconomic life,” according to spokesman Edward Crews. So, theRichmond-based firm has been demolishing the properties andreplacing them with higher-quality apartments and townhomes,most of which are priced much higher than the original rentalunits were. In addition, it has built high-end for-sale units onthese properties.

Gumenick’s strategic plan reveals why the company chose thiscourse. “The costs of servicing conventional construction loansand paying for normal operations, coupled with the extremely lowprofit margins for low-income houses, would force the companyeither to produce substandard structures or to lose money on theproject. Neither alternative is acceptable.” — CHARLES GERENA

The Push to Homeownership


Northern Virginia, as well as militaryand civilian workers transferred toPatuxent River Naval Air Station in St.Mary’s County as part of the Pentagon’srecent base realignments and closures.Contract workers with defense firmshave also moved to the region. All ofthese people have brought their higherwages with them, along with a demandfor higher-quality housing. “It reallytightened the market to the pointwhere local service workers just couldn’tfind housing,” Tourigny says.

Jefferson County is in the samepredicament. Out-of-towners havetransformed a traditionally agrariancommunity with some light industryinto a middle-class refuge that standsin stark contrast with the majority ofWest Virginia. “There are more youngfamilies with larger incomes and col-lege educations moving into theEastern Panhandle,” says TopperSherwood, a consultant for the regionaloffice of Habitat for Humanity. “Thebad news is that they are, by and large, linked to jobs in and aroundWashington.” Today, 50 percent ofJefferson’s residents commute outsideof the county’s borders.

Well-heeled retirees, investors inseasonal housing, and second-homebuyers can have a similar effect whenthey enter housing markets. Residentsin Charleston, S.C., complain aboutthe impact of “drive-by neighbors,”wealthy people who have been reno-vating historic properties into coastalretreats. Their demand has workedhand in hand with local restrictions onnew development to drive up propertyvalues beyond the reach of longtimeresidents.

This contributes to a lack of “filter-ing.” Housing experts expect people tomove up to better homes in moredesirable communities as their finan-cial status improves, leaving behindolder homes in less desirable areas orrental units that others with lowerincomes can move into. However,refugees from hot housing marketscan rapidly bid up prices as they compete for these latter properties.

Filtering may fail to occur for otherreasons. Some homeowners may notwant to upgrade. They may live in anice place and have no mortgage topay. Or, they may be unable to afford amove, even if they sell their home for atidy profit, because housing prices arerising sharply.

Another demand-side factor thathas supported higher housing costs isthe wider availability of cheap credit.“Prices have gone up very dramaticallyin many areas [but] low interest rateshave significantly dampened the effectof those increases,” says Virginia Tech’sKoebel. Also, “we’ve got a tremendousamount of new mortgage products”that give borrowers more flexibilityand allow them to have a higher loan-to-value ratio.

Still, not everyone qualifies for favor-able mortgages, if any. And credit won’tbe cheap forever. Real estate economistsexpect mortgage rates to rise from 45-year lows later in 2005, affecting housingaffordability in the future.

Finally, while median earnings havekept up with housing costs in theaggregate, not everyone in a communi-ty earns the median. Lower-skilled,lower-income workers have experi-enced slower wage growth than those

who are at the median and above,excluding noncash government bene-fits. Also, certain occupations havesuffered from stagnant wage growth at various times, including nursing,teaching, and social work.

Below the MedianFor most of American history, mar-kets met the demands of lower-income people seeking housing,although not always in ways thateveryone considered socially accept-able. In cities, boarding houses, low-rent apartment buildings, and single-room occupancy hotels were availablefor people climbing from the bottomrungs of the economic ladder. Ownersof commercial buildings would addapartments on their upper floors,while immigrant families would buildsimple homes like the brick bunga-lows of Chicago or the Polish flats ofMilwaukee.

Many of these options disappearedin the 20th century when local offi-cials, with the help of federal funding,tore down blighted areas as part ofbroad urban renewal projects. To fillthe need for low-cost housing, govern-ments began building their own.

The construction of federal publichousing began in the 1930s and con-tinued through the ’70s. But by the1990s, this model was widely consid-ered a failure because it removed the incentive for private parties to comeup with affordable alternatives. It alsoconcentrated poorer people into high-rise buildings and sprawling low-rise complexes, many of which weremismanaged and riddled with crimi-nal activity. Now, governments on all levels have shifted gears by spurringothers to develop and operate afford-able housing for those people whoseincomes fall below the median.

Some localities and states offerproperty tax breaks to developers, usually nonprofit groups, in exchangefor building affordable projects andmaintaining their pricing for a mini-mum number of years. (HUD offersLow Income Housing Tax Credits thatprovide a 10-year reprieve from federaltaxes for investors in affordable hous-


In Search of Cheaper HousingHousing affordability isn’t just a problem for thepoor. Middle-income workers have had to movemiles away from the central core of theWashington, D.C., metropolitan area to find housing that doesn’t overwhelm their budgets.

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NOTE: Middle-income households were those earning between$35,000 and $49,999 a year. SOURCE: U.S. Census Bureau, 1999

Percentage of Middle-Income Households That PayMore Than 30% of Earnings on House-Related Costs


ing.) Others create housing trust fundsto finance affordable housing, usingdevelopment fees and other taxes assources of revenue, or provide below-market construction loans to reducedevelopment costs. Banks also providesuch loans to fulfill their legal obliga-tion to meet the credit needs of allareas from which they draw deposits.

But such efforts to subsidize hous-ing development carry risks. “Anyfinancing that distorts the market cre-ates some problems,” says Moises Loza,executive director of the HousingAssistance Council, a Washington-based nonprofit group that examinesaffordable housing issues in rural areas.Some economists say that subsidizeddevelopment can discourage privateinvestment in building new housing orkeeping existing units in the market.

Another approach is to imposeinclusionary zoning on a community.Pioneered in Montgomery County,Md., 30 years ago and used throughoutthe Washington, D.C., metro region,this regulation requires a new residen-tial project to include units that areaffordable to people at a particularincome level (usually a percentage ofmedian income) for a specified period(often 10 years or more).

To help prevent the developer fromraising the prices of the other units tomake the project’s numbers work,Montgomery and other municipalitiesprovide “density bonuses” that allowmore units to be built than the pro-ject’s zoning normally permits.Developers may also get fast-trackpermitting, fee waivers, or exemptionsfrom growth controls.

Inclusionary zoning has succeededin creating additional supply in some areas — more than 10,000affordable units were produced inMontgomery County between 1974and 2001. However, if the factors that are driving up home prices aren’tdealt with separately, even the afford-able units that the builder wasrequired to construct will go up invalue, says Howard Savage at theCensus Bureau. When the units areopen for purchase by any buyer, theywill likely be sold at market prices,eroding the supply of affordable hous-ing. “It doesn’t get turned over toother people who are poor. It gets ren-ovated and the people who have highincomes buy it,” Savage says.

Ultimately, lowering the bar for res-idential development will likely be themost effective way to increase the sup-ply of housing to include units for low-and moderate-income households.That would require a slowing or rever-sal of policies meant to curb sprawland guard property values. Then, someform of rent subsidization, like HUD’sHousing Choice vouchers, could be

provided for the lowest income fami-lies who still couldn’t afford housing.Also, if the real concern is with peopledevoting too much of their incomes tohousing, the Minneapolis Fed’s RonFeldman suggests that governmentsprovide direct assistance to help coverother basic needs.

Meanwhile, working families arefinding ways to cope. For one thing,they may decide to spend more onhousing at the expense of other thingsin the household budget. In extremecases, this could mean paying the phonebill late or skimping on a grocery trip.Usually, it means foregoing some thingsin the short term in order to meet theirlong-term housing needs.

Others have saved money by pur-chasing manufactured homes. Onceepitomized by a flimsy trailer parkedon cinderblocks, this category ofhousing has vastly improved in qualitywhile remaining cheaper to produceand purchase than site-built homes.As a result, many rural residents haveused this route to homeownership —North Carolina, South Carolina, andWest Virginia are among the fivestates in the nation with the highestshare of housing units that are builtoff-site.

For those who are prepared to giveup their neighborhood ties and shoulderthe costs of relocating, families cansearch for affordable housing elsewhere.“People [who] are paying large amountsof their income for housing … reach apoint where they can’t do that anymoreand they move,” says Savage. It is thismigration that has shaken up so manyhousing markets across the country. RF


Collins, Michael, David Crowe, and Michael Carliner. “ExaminingSupply-Side Constraints to Low-Income Homeownership.” WorkingPaper LIHO.01-5, Joint Center for Housing Studies, HarvardUniversity, August 2001.

Crowe, David, et al. Where is Workforce Housing Located? A Study of theGeography of Housing Affordability. Washington, D.C.: NationalAssociation of Home Builders, 2004.

Feldman, Ron. “The Affordable Housing Shortage: Considering theProblem, Causes, and Solutions.” Federal Reserve Bank ofMinneapolis Banking and Policy Working Paper 2-02, August 2002.

Glaeser, Edward L., Joseph Gyourko, and Raven E. Saks. “Why HaveHousing Prices Gone Up?” National Bureau of Economic ResearchWorking Paper no. 11129, February 2005.

Lipman, Barbara. Paycheck to Paycheck: Wages and the Cost of Housing inthe Counties, 2004. Washington, D.C.: Center for Housing Policy, 2004.

Treskon, Mark and Danilo Pelletiere. Up Against a Wall: HousingAffordability for Renters. Washington, D.C.: National Low IncomeHousing Coalition, 2004.

Visit www.richmondfed.org for links to relevant sites and supplementalinformation.

R E A D I N G S

A commuter bus carries Charles County,Md., residents from this Park and Ride to their jobs in Washington, D.C., every morning.

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Here is the brief, unremarkablestory of how I recently cameto participate in the under-

ground economy:Midafternoon on the iciest day this

past winter, a man knocked at myfront door. “Shovel your walk?” heasked. “Only $5.”

Outside, it was a bone-chilling 15 degrees. “Sold,” I said. A half-hour later I handed over a five-dollarbill and thanked him for saving me the trouble.

Officially, this was an unofficialtransaction — off the books, with notaxes paid or safety regulations fol-lowed. (At least, I assume this hiredhand didn’t bother to report thatincome or register with the properauthorities.) As such, it was technical-ly illegal. And, of course, it’s the sort ofthing that happens all the time.

The size of the official U.S. econo-my, as measured by Gross DomesticProduct (GDP), was almost $12 tril-lion in 2004. Measurements of theunofficial economy — not includingillegal activities like drug dealing andprostitution — differ substantially.But it’s generally agreed to be signifi-cant, somewhere between 6 percent

and 20 percent of GDP. At the mid-point, this would be about $1.5 trilliona year.

Broadly defined, the underground,gray, informal, or shadow economyinvolves otherwise legal transactionsthat go unreported or unrecorded.That’s a wide net, capturing every-thing from babysitting fees, to barter-ing home repairs with a neighbor, tofailing to report pay from moonlight-ing gigs. The “underground” labeltends to make it sound much more sin-ister than it really is.

Criminal activities make up a largeportion of what could be termed thetotal underground economy. Manystudies have been done on the eco-nomics of drug dealing, prostitution,and gambling. But because moneyfrom crime is almost never recovered,many policymakers are more interest-ed in portions of the undergroundeconomy that otherwise would belegal if not hidden from authorities.Things like shoveling walks.

Despite its intrigue, the informaleconomy’s importance and conse-quences remain in debate. The reason:“You’re trying to measure a phenome-non whose entire purpose is to hide

itself from observation,” says Ed Feige,an economist at the University ofWisconsin.

This uncertainty poses problemsfor policymakers. Without knowingthe precise size, scope, and causes ofthe underground economy, how canthey decide what — if anything — todo about it?

Was the man who shoveled my walkengaging in a socially positive or nega-tive activity? Was I? Suffice it to say,some economists have dedicated theirentire careers to answering questionsabout the underground economy —and still there is nothing close to a con-sensus about its size or description.

Elusive DefinitionFriedrich Schneider, an economist atthe Johannes Kepler University inLinz, Austria, defines the informaleconomy as: “All market-based legalproduction of goods and services thatare deliberately concealed from pub-lic authorities for the following rea-sons: 1) to avoid payment of income,value added, or other taxes 2) to avoidpayment of social security contribu-tions 3) to avoid having to meet cer-tain legal labor market standards,


Economists believe as much as 10 percent of

the U.S. economy is “underground.”

Is that such a bad thing?

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such as minimum wages, maximumworking hours, safety standards, etc.,and 4) to avoid complying with cer-tain administrative procedures, suchas completing statistical question-naires or other administrative forms.”

In Schneider’s latest study, the U.S.informal economy — or “shadoweconomy,” as he calls it — is pegged at8.4 percent of GDP. His estimate wasderived using a combination of twoestimation methodologies: one thatmeasures demand for currency andanother a mathematical model thatseeks to consider multiple causes ofthe underground economy as well asits multiple effects.

Other approaches include examiningthe discrepancy between spending andincome, as claimed in tax filings; the gapbetween the official and actual laborforce; and comparing electricity con-sumption with reported economicactivity. Using a variety of methods, eventhe keepers of the national accounts,which produce GDP figures, try to tallythe impact of the unreported economyin estimating the official economy.

Ed Feige, the University ofWisconsin economist, favors methodsthat study cash stocks and flows. Hisresearch focuses on the “unreportedeconomy,” which involves transac-tions whose purpose is to evade taxes.His latest work puts the 1993 unre-ported economy at $700 billion.

None of these approaches is per-fect or precise. “To some authors, thewhole exercise is doomed to failure,”writes English economist Huw Dixonin a 1999 introduction to a series ofjournal articles about the under-ground economy. “If we have no directmeasure, then indirect measures arelikely to be no better than guessti-mates, which should be taken at bestas interesting novelties.”

Given the level of doubt about thesize of a nation’s overall undergroundeconomy, it’s no wonder that region-al estimates are hard to come by. TheInternal Revenue Service studies taxevasion on a national level and in1998 quantified revenue losses at$195 billion — most of that believedto be the result of the transactions

taking place in the undergroundeconomy. But there exists no state-by-state study of tax evasion, largelybecause politicians representingtheir districts don’t want that kind ofinformation released.

This makes it risky to attemptapproximations of a region’s under-ground economy. If you trustSchneider’s work, you might make asimple extrapolation: The FifthDistrict’s economy is valued at about$1 trillion a year, as calculated byadding up each “gross state product.”That’s about 10 percent of the overallU.S. GDP. So if the Fifth District’sblack market is in proportion withSchneider’s estimate for the rest of thenation’s, then we can estimate that theregion’s underground economy isworth about $84 billion.

Whether the informal economy ismore active in rural or urban settingsalso remains to be settled. ShannaRatner, an economic developmentconsultant who studies informaleconomies in rural settings, thinksthey’re close to equal. Conditions likepoverty and economic immobility —considered likely features of manyinformal economies — prevail in bothinner-city and back-country environ-ments. Farmers looking for a competi-tive edge are just as likely to hire illegalimmigrants as inner-city warehousemanagers.

Observers like Ratner are reluctantto judge those participating in infor-mal economies, be they employers orhired hands. “I don’t think it is in itselfeither a good thing or a bad thing,”Ratner says. “It has to be viewed incontext. When the informal sectorresults in activities that strengthensocial capital, because they’re relation-ship-based, one could argue that’s agood thing. When the informal sectoractivities are illegal because they’reharmful … then that’s arguably a badthing.” In a 2000 paper about theinformal economy, Ratner citedinstances of home-based production(everything from arts and crafts tolaundry) as a crucial means to “closethe gap between wages and humanneeds and wants.”

Looking for the UndergroundTo get a better idea of how a full-fledgedunderground economy operates, I wentto Floyd, Va. On paper, Floyd looks likejust the sort of place where a rural-styleinformal economy should be thriving.Here is an Appalachian community witha rich history of barter. Writing aboutlife just across the border in WestVirginia, historian Paul Salstromdescribed it this way: “Appalachia’s maineconomic anomaly was that distributiverelations remained less monetizedthere; they remained composed more ofbartering and borrowing.” A short driveaway is Abingdon, Va., home of the“Barter Theatre,” founded in the 1930sas a place where local farmers couldswap their crops for admission to a play.

There is no interstate coursingthrough Floyd. Its downtown is criss-crossed only by two-lane highways.Median family income in the county is$38,128 compared with $54,169 amongall Virginia counties. Even in the rela-tively poor New River Valley, FloydCounty stands out with its low taxablesales base, bank deposits, and highpoverty rate. There has been a flight ofmanufacturing employers, creatingmore unemployed and underemployedpeople seeking work wherever theycan get it, even if it’s off the books.

David Rundgren, executive direc-tor of the New River Valley PlanningDistrict Commission, says on-the-sideeconomies are part of Floyd’s culture.“Throughout history these folks havebeen fairly independent and tradingwork with each other,” Rundgren says.

For me, the big draw to this townwere “Floyd Bucks” — Floyd’s owncurrency. Officially called the “FloydHours,” blue-colored bills were print-ed in 2002 by a nonprofit group whoseaim was to “make a statement in support of our local economy,” saysDawn Shiner, founder of Floyd’s community currency effort. A “one-hour” bill is pegged to an estimatedvalue of one hour’s worth of labor, or $10. There are also quarter-hourbills valued at $2.50.

Informal economies do not requiretheir own currencies. Indeed, mosttransactions in the informal economy



probably are done in official U.S. currency, and those conducted in alter-native currencies are supposed to besubject to taxes. And what I actuallyfound in Floyd was an environmentnot unlike any small town across theUnited States: Sure, people are inde-pendent and will trade goods and services when it suits them, but U.S.currency and regulated work fareclipse the underground economy.

At the Harvest Moon, which localsrefer to as the health food store, ownerMargie Ryan says that in principle, shelikes to barter whenever possible. Inpractice, it’s not so easy, which is whyshe stopped accepting “Floyd Bucks.”

“It’s part of the overall culture ofworking together to get thingsdone,” Ryan says. “But everybodywanted to use those bills here, and I don’t need so many labor hours.I need to pay my bills.”

A quick survey of downtown retailestablishments in Floyd revealed simi-lar sentiments. From the hardwarestore to an art gallery, the answers werethe same. A hostess at Mama Lazardo’sPizza summed it up: “I have ’em, but I have no way to spend ’em.”

Shiner modeled the Floyd Hoursafter upstate New York’s Ithaca Hours,the most successful community cur-rency in the United States. More than$105,000 in Ithaca Hours have beenissued since 1991, and an estimated400 businesses in the region acceptthem. “Community currency systemsare excellent tools to help revitalize

local economies since they encouragewealth to stay within a communityrather than flowing out of it,” EdCollom, a University of South Maineprofessor, wrote in a recent article.

Floyd Hours haven’t enjoyed nearlythat level of success. Shiner guessesthat only $500 in Floyd bucks was ever printed. Originally, there was adirectory of some 20 business estab-lishments that accepted them; today,none are known to.

“In this culture it’s hard to expectany of us to just use local currency,”Shiner says. “It’s a supplemental thing.It’s a statement saying ‘I believe in my region,’ a way to facilitate more exchange and a way to help othersknow what’s available in our region.”The fact is, Floyd’s currency, like itsinformal economy, is hard to detect.

The Other PathThose concerned about undergroundeconomies point to nightmare scenarioslike the one captured in Hernando deSoto’s book The Other Path, whichdescribed how burdensome govern-ment regulations in Peru spawned anunderground economy that encom-passed 38 percent of GDP.

Enrique Ghersi, de Soto’s co-author in Spanish-language versions ofthe book, defined this informal econo-my as entailing “activities that do notintrinsically have a criminal content,but must be carried out illicitly, eventhough they are licit and desirableactivities for the country … Thus, from an economic point of view, the most important characteristic of informal activities is that thosedirectly involved in them as well associety in general benefit more if thelaw is violated than if it is followed.”

Almost 20 years after describingPeru’s plight, economists generallyagree that the shadow economy isworse in developing nations, whosewebs of bureaucratic red tape and cor-ruption are notorious. For instance,Schneider in 2003 published “shadoweconomy” estimates (defined broadlyas all market-based, legal productionof goods and services deliberately

concealed from the authorities) forcountries including: Zimbabwe, esti-mated at a whopping 63.2 percent ofGDP, Thailand’s at 54.1 percent, andBolivia’s at 68.3 percent. Among for-mer Soviet bloc nations, Georgia ledthe way with a 68 percent of GDPshadow economy, and together thosenations had an average 40.1 percent ofGDP underground. This contrastswith an average of 16.7 percent amongWestern nations.

Some of Schneider’s estimates ofthe size of the underground economyare controversial; critics say that hehas jumbled different definitions ofthe underground economy in his esti-mates and sometimes not matchedmeasurement methods, thus makingcomparisons less meaningful. But fewquibble with his reasons for payingattention to the underground:

• If it’s growing, it may be a “reactionof individuals who feel overburdenedby the state.” As a result, they chooseto dodge the taxes or safety regulationsor licensing requirements that the stateimposes, instead joining the under-ground. In this kind of world, the offi-cial economy declines, often leading tobudget deficits and climbing tax rates.

• Official statistics — like GDP —may be rendered less useful if theydon’t really capture the breadth of eco-nomic activity.

• It could be used as an unfair com-petitive advantage. Employers whohire undocumented immigrants underthe table, for example, enjoy costadvantages over firms that properlyreport their employees and pay taxeson them.

In a 2004 paper, the McKinseyGlobal Institute found that countrieswith big informal economies sufferproductivity losses. That’s basicallybecause the smaller firms that partici-pate in the shadow world never gainthe scale and complexity of their official competitors, whose ownoperations are hampered by the exis-tence of their under-the-table rivals.

“The powerful incentives anddynamics that tie companies to thegray economy keep them subscale andunproductive,” researcher Diana


Locals call them “Floyd Bucks,” but these billsare officially called Floyd Hours. A small groupof residents in Floyd, Va., printed their own cur-rency as part of an effort to keep business local.


Farrell wrote. “Second, the cost advan-tages of avoiding taxes and regulationshelp informal companies take marketshare from bigger, more productiveformal competitors.”

Farrell’s solution: Wake up, officialeconomy! She advocates strengthen-ing enforcement, eliminating red tape,and cutting taxes. “Persistent mythskeep developing countries fromaddressing the informal sector,” shewrites. “Yet diminishing its size would,in almost every case, remove barriersto growth and development and gener-ate sizable economic gains.”

But What about Here? Not surprisingly, the Internal RevenueService has an interest in the under-ground economy. In recent papers,Kim Bloomquist, senior economistwith the IRS, has aimed to shoot downtheories that this nation’s tax code isto blame for a large portion of theinformal economy. Acknowledgingthat tax evasion is on the rise,Bloomquist asks the obvious question:“If neither increasing complexity nor arising tax and regulatory burden canadequately explain the growth in non-compliant behavior, what else couldaccount for this phenomenon?”

His short answer: There’s been ageneral shift away from more visible toless visible sources of income. Wherethis plays out most frequently is in thewealthiest and poorest U.S. house-holds. The middle class — people with9-to-5-sort-of jobs — is extraordinarilywell-documented, with few easyopportunities to avoid paying taxes.

By contrast, high-income householdscollect a larger percentage of theirincome in the form of “nonmatchable”income, which is money not subject tothird-party information reporting andwithholding (like typical wages, divi-dends and social security benefits).Taxpayers in the top 5 percent of theincome distribution account for morethan 77 percent of this nearly “invisi-ble” income, Bloomquist says.

On the other end of the scale, thepoorest Americans are more likely todeal in cash and thus less likely to besubject to third-party reporting.

These trends worry economists likeBloomquist, especially as incomeinequality widens in the United States.“Further polarization of the nation’sincome distribution could act to under-mine current and future tax-enforce-ment efforts,” he wrote in a 2003 paper.

Meanwhile, the informal economycruises along. Nobody is terribly exer-cised about scrip currency in Floyd.Neither myself nor the guy who shov-eled my walk fear reprisal from author-ities. And we are arguably better for it:There was an immediate demand for ashoveled walk and he offered the supply.Talk about efficient.

Feige, the University of Wisconsineconomist, strives for clarity. Hescorns studies that lump the unreport-ed, unrecorded, and illegal economiestogether without explaining their dis-tinctions. He believes much of theresearch on informal economies suf-fers because of authors’ failures tostick to uniform definitions of whatconstitutes “underground.”

And though he considers the prob-lem of unreported, unrecorded, andinformal economic transactions to beworse in developing countries, he isnot so fast to write off the UnitedStates’ experience as inconsequential.“Shifting the burden to honest taxpay-ers has significant implications,” hesays. Schneider, the Austrian econo-mist, is of two minds about the U.S.underground: “A very difficult ques-tion,” he says. “I think a shadow econ-omy of 10 percent, which leads toadditional value added has an overallpositive effect on the welfare of theUnited States.” But a case can be madethat tax losses from even a 10 percentshadow economy are too great for thestate to ignore, he adds.

In his 2003 book, Reefer Madness:Sex, Drugs and Cheap Labor in theAmerican Black Market, investigativewriter Eric Schlosser invokes AdamSmith’s “invisible hand” theory thatmen pursuing their own self-interestwill generate benefits for society as a whole. This invisible hand has produced a fairly sizable undergroundeconomy, and we cannot understandour entire economic system withoutunderstanding how the hidden under-belly functions, too. “The under-ground is a good measure of theprogress and the health of nations,”Schlosser writes. “When much iswrong, much needs to be hidden.”Schlosser’s implication was that muchis wrong in the United States. If hehad taken a more global view, hemight have decided relatively little ishidden here. RF


Bloomquist, Kim. “Tax Evasion, Income Inequality and OpportunityCosts of Compliance.” Paper presented at 96th Annual Conferenceof the National Tax Association, Chicago, November 2003.

de Soto, Hernando. The Other Path: The Invisible Revolution in theThird World. New York: Harper & Row, 1989.

Dixon, Huw. “Controversy: On the Use of the ‘Hidden Economy’Estimates.” Economic Journal, June 1999, vol. 109, issue 456, pp. 335-380.

Feige, Edgar. “Overseas Holdings of U.S. Currency and theUnderground Economy.” Economics Working Paper Archive atWashington University, St. Louis, January 2005.

Ratner, Shanna. “The Informal Economy in Rural CommunityEconomic Development.” TVA Rural Studies Contractor Paper 00-03, February 2000.

Schlosser, Eric. Reefer Madness: Sex, Drugs and Cheap Labor in theAmerican Black Market. Boston: Houghton Mifflin Co., 2003.

Schneider, Friedrich. “The Size of the Shadow Economies in 145Countries All over the World: First Results over the Period 1999to 2003.” IZA Discussion Paper no. 1431, December 2004.

Visit www.richmondfed.org for links to relevant sites and supplemental information.

R E A D I N G S


E ven if you’re not familiarwith the term “stickyprices,” you encounter

them all the time. How many yearshas your newspaper sold for 50 cents a copy? No matter if interest rates are moving up or down, the price ofyour newspaper hardly ever changes— it’s sticky.

Economists take for granted thatsome prices are rigid, slow to shifteven as supply and demand condi-tions might seem to warrant. Formany economists, these “nominalfrictions” are enormously important,a core reason why monetary policymatters.

For other economists, however,sticky prices are neither widespreadnor meaningful in the slightest forpublic policy.

Differences of opinion are hum-drum stuff in economic circles. Buton the issue of sticky prices, the levelof disagreement is sharp and raisessome exceptionally high stakes.Economists build mathematical models that are supposed to help policymakers decide when and howmuch to change interest rates. Inrecent years, sticky-price models havegained currency and are being used to inform Fed decisionmakers in setting interest rates.

But if sticky prices don’t reallymatter for monetary policy, as someprominent economists theorize, thenwhat use are sticky-price models tothe Federal Reserve System?

More to the point: If sticky pricesdon’t matter, does the Fed?

The behind-the-scenes debateabout the importance of sticky pricesis going on at the uppermost levels ofeconomic thinking. Ben Bernanke, aFed governor on leave from PrincetonUniversity’s economics department,referred optimistically to the evolu-tion of sticky-price models in a 2004speech: “The insights from thesetypes of modeling efforts are alreadyinforming policy analysis at theBoard, and their influence will onlygrow as they become more detailedand realistic.”

But where Bernanke sees promisein sticky-price models, others seeinescapable flaws. Patrick Kehoe,monetary adviser at the MinneapolisFed — whose president, Gary Stern,is a voting member in 2005 on theFederal Open Market Committee —suggests that economists ditch fur-ther research on sticky-price models.“No one has really yet made a con-vincing quantitative case for them,”he says.

It is difficult to predict when, ifever, a resolution will happen. Buthow the sticky-price debate is settledmay have significant implications forpublic policy.

A Sticky-Price IllustrationAt the supermarket, the price of a boxof brand-name cornflakes seldomfluctuates. For months it may be$2.49, perhaps going on sale for $1.99.As long as it stays at within those two bounds, the price of cornflakes is considered sticky.

Intuitively, you might expect morefrequent price changes for a box of

cornflakes. Say it was a bumper cropyear for corn — shouldn’t the price of cornflakes then fall because of theincreased supply? But for microeco-nomic reasons they don’t budge. Firmsmust weigh factors like “menu costs”— literally, the cost of setting newprices as on a restaurant menu — andthe psychological impact on customerswho are accustomed to the old price.Simply put, prices tend to change onlywhen it’s financially advantageous forthe producer to do so. Similar reason-ing can be applied to changes in work-ers’ wages.

The fact that prices don’t continu-ously move is believed by many economists to be the key insight intohow monetary policy can affect theeconomy. It is an underlying justifi-cation for so-called “monetary non-neutrality” — that is, why money matters. This is in contrast to “monetaryneutrality,” which posits that an increasein the money supply would simply beoffset by rises in prices and wages.

When the Fed sets policy for the federal funds rate, it is influencing the growth of the money supply. If prices weren’t sticky, and in theabsence of other frictions, then theo-retically the Fed’s actions wouldn’tmatter for economic output. Putanother way, if there’s more moneyavailable with no change in prices,then consumers theoretically will buymore cornflakes. Cornflakes seemcheaper in this scenario. Conversely,if there’s less money in circulation,shoppers will dial down their corn-flake purchases since their price nowseems high. Because prices don’t

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Are they sticky enough to affect monetary policy?

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immediately adjust, the Fed’s behav-ior has the potential to affect the realeconomy.

The degree to which some econo-mists believe prices are sticky tendsto shape their beliefs on monetarypolicy. Sticky-price fans tend to bemore optimistic about the potentialimportance of monetary policy, whilesticky-price disbelievers often viewmonetary policy choices as relativelyunimportant. At the same time, bothsides are inclined to agree that pricestability is the most desirable out-come of monetary policy — and gen-erally don’t subscribe to the oldKeynesian notion that the centralbank should use monetary policy totry to fine-tune the economy. It’s just that sticky-price believers viewmonetary policy as effective becauseof the existence of sticky prices; theskeptics see monetary policy’s powersas more wrapped up in how successfulthe central bank is at communicatingits intentions and not surprising themarket with wild fluctuations ininterest rates.

Today, macroeconomists rely onintricate economic models to examinethe impact of the money supply onthe real economy. Those models inturn inform policy deliberations ofthe Federal Open Market Committee.There now exist two main schools ofthought: one that thinks sticky pricesmatter and any modeling that doesn’tuse them will produce misleadingresults; the other that sticky pricesdon’t matter and that standard real-business-cycle models work just fine,thank you very much.

These camps are neatly encapsu-lated in the views of two leading econ-omists: Jordi Galí and the aforemen-tioned Patrick Kehoe. In between isAlex Wolman, an economist with theFederal Reserve Bank of Richmondwhose sticky-price research is widelycited.

The BelieverGalí is a professor at the UniversitatPompeu Fabra in Barcelona, Spain,who has concentrated on monetarypolicy and the business cycle. He is a

passionate believer that sticky pricesplay an important role in explaininghow monetary policy works.

“Not only do they matter but theyare probably the single most impor-tant reason why monetary policyplays such a central role in moderneconomics,” Galí says. “In the absenceof nominal frictions, monetary policywould be largely irrelevant and infla-tion and its costs a secondary concernat most.” With that theoretical under-pinning, Galí is forging ahead withresearch on the interaction betweensticky prices and monetary policyrules.

Much of his work seems todebunk long-held views about howthe business cycle works. For example,Galí and two co-authors argued in a recent paper that it’s because ofsticky prices that increased govern-ment spending may actually raiseconsumption among forward-thinkingconsumers.

This is in contrast with the prediction of standard “neoclassical”economic models, which suggest thatsuch expenditures may not have thiseffect because individuals are fore-sighted and recognize that a govern-ment that increases spending todaywill likely have to decrease spending or raise taxes in the future; as a result,those consumers do not necessarilyalter their consumption patterns.While Galí and his neoclassical colleagues may disagree over theempirical effects of increased govern-ment spending, both sides cautionthat economic analysis alone cannotdetermine whether such spending isdesirable.

The SkepticOver at the Minneapolis Fed, PatrickKehoe is doubtful. In reviewing thepast two decades’ work on sticky-pricemodels, Kehoe sees rampant shortcom-ings. No work, he says, has succeeded inreplicating output blips like those seenduring the Great Depression. “Mostpeople who play the sticky price gamedon’t try to account for episodes in thedata,” Kehoe says. “The way the mone-tary literature has gone recently, they

seldom ask serious questions like that.”As ammunition, Kehoe points to

some recent research on just how un-sticky prices in the U.S. market reallyare. In 2002, Mark Bils of the Uni-versity of Rochester and Peter Klenowof Stanford University first reportedfindings from their look into a newtrove of data: previously unpublishedinformation on individual consumerprices collected by the Bureau ofLabor Statistics. In aggregate, thosedata make up the consumer priceindex, compiled by governmentemployees who literally observe pricesof hundreds of individual products,from groceries to magazines, store bystore. Bils and Klenow got special per-mission to review the micro-data onprices and concluded that these pricesactually change quite frequently, onaverage about every four months. Thatdoesn’t seem so sticky, Kehoe argues.Additionally, Kehoe cites new researchsuggesting that when prices change,they do so in big chunks, much biggerthan relative to what you’d expectbased just on money shocks.

Thus to Kehoe, much of the work


Average No. of MonthsProduct/Services Between Price ChangesNewspapers 29.9Haircuts for men 25.5Beauty parlor services 22.9Film processing 18.2Cemetery lots 13.5Paint 7.0Computer software 5.5Prescription drugs 5.4Pet food 5.2Beer 4.3Cigarettes 4.1Jewelry 3.7Cereal 3.4Women's footwear 3.0Lunch meats 3.0Ice cream 2.7Frozen orange juice 2.4Roasted coffee 2.2Bananas 1.8Women's dresses 1.5Eggs 1.0Airline fares 0.9Tomatoes 0.8Unleaded gasoline 0.6

SOURCE: Data selected from Bils and Klenow (2004)


on sticky-price models is pointless.Unable to produce results that matchactual economic data, sticky-priceenthusiasts are reduced to weakly argu-ing that their models can account forwhat happens after a monetary shockwhile admitting that monetary policy,broadly defined, accounts for only atiny fraction of the business cycle,Kehoe says. “If that’s true, then why arewe looking at it in the first place?” heasks with exasperation in his voice.

Galí counters the criticism thatsticky-price models don’t explainperiods like the Great Depression byreferring to new variations of sticky-price models that have been enrichedwith features like habit formationand capital adjustment costs. In thesemodels, “It is much easier to generatepersistent output fluctuations, evenin response to monetary policyshocks,” he says. Equally, Galí arguesthat just because he believes in thepower of sticky prices doesn’t meanhe thinks they’re the only importantfactor in the economy. “The fact thatnominal rigidities play an importantrole in the economy does not neces-sarily imply that monetary policyshocks should be an important sourceof fluctuations; there are othershocks in the economy.”

The ModerateOn the matter of sticky prices, theRichmond Fed’s Alex Wolman is some-thing of an agnostic. Wolman got in onthe ground floor of modern sticky-price modeling through his serendipi-tous association with Robert King,then a professor at the University ofVirginia, where Wolman was a Ph.D.student. King — now at BostonUniversity and a consultant to theRichmond Fed — was at the forefrontof incorporating sticky prices intoequilibrium business cycle models.

Since the 1990s, Wolman hasworked with both so-called “state-dependent” and “time-dependent”sticky-price models. In state-depend-ent models, firms essentially are pre-sented with an economic choiceabout whether it’s a good time or badtime to switch prices, and the sole

criterion for making that decision iswhether it will cost more to the firmto keep prices stable than to incur amenu-type cost to change them. Bycontrast, in “time-dependent” models,prices are automatically changed ornot after a certain period.

Wolman argues that state-depend-ent models are superior to time-dependent versions because they moreaccurately mirror the real economy.They don’t impose so much structureon firms as they allow them to decidewhen to adjust prices based on envi-ronmental conditions — whether it’scheaper to leave prices unchanged ornot. But the trade-off is that state-dependent models are more technical-ly involved, so on occasion Wolmanprefers to work with time-dependentmodels. Among other things, Wolmanhas used time-dependent sticky-pricemodels to argue that the Fed isn’t pow-erless when nominal interest ratesreach zero.

Wolman continues his researchwith sticky-price models. He is tryingto both understand them better —especially their implications for mon-etary policy — and to advance them.As widely used as sticky-price modelsare today, they still aren’t all that wellunderstood, he says.

Long-term, where Wolman seesthe most promise is where Kehoesees the most problems. The sameBils and Klenow data that showedshorter periods of time betweenprice changesalso show

enormous variance, or “heterogene-ity.” Wolman thinks sticky-pricemodels can begin to incorporate thevast differences in how firms changeprices — something that nobody hasreally accomplished yet. “It’s notstraightforward to write down andsolve models with those features,” he says. “What we need to under-stand is how that heterogeneity inthe frequency of price adjustmentmatters.” The upshot, Wolmanhopes, will be a model that producesresults more consistent with actualeconomic data.

Building such a model is impor-tant because it will help us get at thecentral issue of this debate: theextent to which monetary policy andthe Fed matter in the real world.

The irony that a monetary skepticis serving as monetary adviser at aFederal Reserve bank is not lost onKehoe. But he doesn’t necessarily seeit as a conflict. To be sure, there isevidence that monetary policy runamok can severely damage an econo-my — witness runaway U.S. inflationin the late 1970s, a phenomenonmany economists including Kehoeattribute to the Fed’s poor handlingof the money supply.

At the same time, Kehoe thinksthe reverence with which the U.S.Federal Reserve System is held bysome may be overstated. The Fed cannot hope to smooth every blip inthe economy with monetary policy, he says, because it doesn’t really wield that kind of power. The per-ceived failure of sticky-price models iscase in point for Kehoe. “I could wellimagine that monetary policy is

important in a variety of ways, but Idon’t think that the profession ingeneral and sticky-price enthusi-

asts in particular have a handle onthe mechanism by which it is,” hesays. “I’m perfectly comfortableworking at the Fed without thinkingthat the Fed can save the day for everyrecession and at the same time thinkit’s important to keep prices stable.”

Perhaps surprisingly, sticky-priceenthusiast Galí somewhat sharesthat sentiment: “The presence of


“We as economistsdon’t know exactlyhow what the Fed

does matters for thereal economy.”



high and persistent levels of un-employment in many industrialeconomies can hardly be attributedto nominal rigidities. At most, monetary policy can provide a temporary patch.”

In other words: Monetary policyis not the cure-all salve for the econ-omy that the popular media havelately told you about. Both Kehoeand Galí agree that it’s good for somethings, but not all things — thoughGalí is more enthusiastic about itthan Kehoe.

Their differences are nuanced butimportant. With regard to monetarypolicy, Kehoe is content to shoot forgeneral price stability and then let thereal economy work out other kinkson its own. Gali, by contrast, draws astrong connection between the exis-tence of sticky prices and the effec-tiveness of monetary policy. Becauseof this, he has greater confidence in monetary policy’s ability to guidethe behavior of the real economy.

Wolman isn’t at all ready to giveup on sticky-price modeling, but hethink a lot more work remains: “I believe what the Fed does matters.But we as economists don’t knowexactly how what the Fed does matters for the real economy.”

He pauses. “It’s slow going forpeople to reach a definitive conclu-sion about the effects of Fed behav-ior on the real economy. Hopefully,by gathering more data and buildingmore models, we can become betterinformed about this question.” RF

Bernanke, Ben S. “Monetary Policy Modeling: Where Are We andWhere Should We Be Going?” Remarks at the Federal Reserve Board Models and Monetary Policy Conference, Washington, D.C.,March 27, 2004.

Bils, Mark, and Peter J. Klenow. “Some Evidence on the Importanceof Sticky Prices.” Journal of Political Economy, October 2004, vol. 112,no. 5, pp. 947-985.

Chari, V. V., Patrick J. Kehoe, and Ellen R. McGrattan. “Sticky Price Models of the Business Cycle: Can the Multiplier Solve the Persistence Problem?” Econometrica, September 2000, vol. 68, no. 5, pp. 1151-1179.

Galí, Jordi. “New Perspectives on Monetary Policy, Inflation, and theBusiness Cycle.” National Bureau of Economic Research WorkingPaper no. 8767, February 2002.

Dotsey, Michael, Robert G. King, and Alexander L. Wolman. “State Dependent Pricing and the General Equilibrium Dynamics of Money and Output.” Quarterly Journal of Economics, May 1999, vol. 114, no. 2, pp. 655-690.

Kydland, Finn E., and Edward C. Prescott. “Rules Rather Discretion:The Inconsistency of Optimal Plans.” Journal of Political Economy,June 1977, vol. 85, no. 3, pp. 473-492.

Wolman, Alexander L. “Real Implications of the Zero Bound onNominal Interest Rates.” Federal Reserve Bank of RichmondWorking Paper no. 03-15, December 2003.

Visit www.richmondfed.org for links to relevant sites.

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China is famous for its exports,but this nation of 1.3 billionpeople is also one of the

world’s biggest importers. Thanks tothe falling dollar, it may become evenmore so. In 2004, China boughtmachinery from firms in Marylandand Virginia. China also bought woodfrom North Carolina — lots of it.China bought organic chemicalsfrom South Carolina and plastic fromWest Virginia. And China isn’t theonly country buying U.S. goods — thedollar is making U.S. prices look goodthese days.

After cresting in 2002, the dollarhas retreated to exchange rates notseen since the mid-1990s. Overall,the weakened dollar helped lift FifthDistrict exports during 2004 by 13.5percent, with $53.2 billion worth ofgoods being sent overseas.Manufacturers of chemicals, machin-ery, plastic, and vehicles have seenthe biggest gains. Wood exports alsogrew, while apparel and woven fabricexports dropped off.

But does the falling dollar portendtrouble if theUnited Statesmust keep bor-rowing from for-eign investors tofinance its con-sumer and gov-ernment spend-ing? Or will thed e p r e c i a t i o nenhance U.S. com-petitiveness andhelp keep eco-nomic growthstrong?

Falling Dollar, Rising ExportsEconomists are debating the long-term implications, but the falling dol-lar’s impact in 2004 was favorable formany U.S. firms. North Carolina

exported $18 billion worth of goods in2004, 11.3 percent more than 2003.“The weaker dollar’s having a hugeimpact on our business worldwide,”says Peter Cunningham, director ofthe International Trade Division at theNorth Carolina Department ofCommerce.

The Tar Heel state exported 50 per-cent more pharmaceutical products in2004 than it did in 2003, but it alsoexported almost 22 percent more cot-ton and yarn. And $5.4 million of thecotton and yarn exported went toChina, an increase of 36 percent tothat country. Knit apparel, however,dropped by nearly 19 percent, a trendthat many think will continue.Likewise, South Carolina sent 63 per-cent more cotton and yarn abroad lastyear, with China being its second bestcustomer.

Strong cotton and yarn sales fueloverseas apparel shops, says DonaldBrasher, president of Global TradeInformation Services, based inColumbia, S.C. North Carolina is theNo. 1 exporter of cotton yarn, andwith the removal of textile quotas,China will produce even more apparelfor export. That may be bad news forwhat’s left of the Fifth District appar-el sector. But China is going to needcotton — lots of it. “We might besending more yarn to China or we maybe just sending more raw cotton,”Brasher notes.

Will China buy another traditionalFifth District manufactured product— furniture? Perhaps. In 2004, NorthCarolina exported about 23 percentmore furniture and bedding to Chinathan the previous year.

North Carolina exported about$253 million in furniture and beddingin 2004, about 3 percent more than2003, according to Global TradeInformation Services. Most furniturecompanies have not embraced the

The falling dollar has made

American goods more attractive

to consumers abroad, but not

everyone is happy about the

currency’s slide

BY BET TY JOYCE NASH

AND JENNIFER WANG

Going Abroad State Merchandise Export Totals

State Exports 2003 Exports 2004 % changeDistrict of Columbia 809,220 1,164,327 44Maryland 4,940,631 5,746,142 16North Carolina 16,198,733 18,114,767 12South Carolina 11,772,894 13,375,890 14Virginia 10,852,981 11,630,744 7West Virginia 2,379,808 3,261,683 37Fifth District 46,954,267 53,293,553 14United States 723,743,177 817,935,849 13

NOTE: Figures are in thousands of dollarsSOURCE: Department of Commerce

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export strategy but are beingurged to expand to internationalmarkets because of the fallingdollar. North Carolina’s biggestfurniture customers in 2004were Canada and Australia.

“I use this example: A $500sofa two years ago would havecost 560 euros, today it’s about400 euros,” says Jeremy Ruff ofthe North Carolina Departmentof Commerce’s Furniture TradeOffice. “Just the difference inthe exchange rate is pretty dramatic.”

For exporters, the effect of thedeclining dollar is easy to understand:A depreciated dollar makes U.S. goodsmore affordable. And more foreigntourists travel in the United Statesbecause their money goes further. Onedollar was worth .76 euros in March, soa $5 lunch cost 3.81 euros for Germantourists in Washington, D.C.

Linda Yelton, manager of interna-tional research at the Travel IndustryAssociation of America, notes thattravel to the United States fromEurope, the United Kingdom, andAsia increased last year. In total, over-seas travel to the United States rose by14 percent over 2003.

Fifth District companies are bene-fiting from increased internationaltourism indirectly as well as directly. InFebruary, Goodrich Corp. ofCharlotte, N.C., announced a contractworth $6 billion over 20 years with air-plane maker Airbus of France.

How Low Can You Go?The dollar may be falling but it hasn’t tumbled enough to suit CliffWaldman, an international economistfor the trade group ManufacturersAlliance. He thinks the dollar needs tokeep dropping to close the ever-widen-ing trade deficit, which reached almost6 percent of gross domestic product in

late 2004. Waldman notes that thegrowth in demand for U.S. exports hasmoderated as economic activity in cer-tain key countries has weakened, namelyGermany and Japan.

“In terms of what we really need tosee the dollar do, it has not gone back tothe levels where we needed it to becompetitive,” Waldman says. He pointsout that in the early 1990s, the dollarappreciated more than 70 percent from1992 to February of 2002, and almost40 percent of that occurred from 1995to 2002. Since then, the dollar hasdeclined roughly 40 percent against theeuro, but considerably less against alarger basket of currencies.

Likewise, Michael Walden, an econ-omist at North Carolina StateUniversity, sees no threat in the declin-ing dollar. He believes the dollar wasovervalued prior to its recent decline.

“We’re at a level commensurate withwhere we were in the mid-1990s. It’s going to have a positive impact onour economy,” he says. “It’s an automat-ic stabilizer, if one is worried about the trade deficit. It stimulates exportsand makes imports more expensive,eventually.”

America’s Savings RateThe capital flowing into the nationfrom abroad has financed consumerand government spending, reflecting

the lack of domestic savings,one piece of the dollar puzzle. Ifforeign investment falls, theUnited States could be stuckpaying higher interest rates.

Federal Reserve BoardGovernor Edward Gramlichrecently focused on savings in aspeech, concluding: “In theshort run, output growth ishealthy and inflation rates arestable. Investment shares arereasonable, but that is largely

because the United States is borrow-ing such a huge amount from worldcapital markets. The key question iswhether this borrowing is sustainable.However sustainable it is, the UnitedStates would seem well-advised tominimize risks by raising its ownnational saving to finance its owninvestment. That would stabilizeinvestment in the short run andincrease profitability in the long run.”

Walden notes that personal savingscalculations don’t capture capitalappreciation in such things as homesor 401(k) plans. Also, one “could arguethat education and research are invest-ments,” and compared to other coun-tries, the United States spends a highshare of its national product on thosethings.

While the falling dollar has benefit-ed American exporters, the effect onsome domestic manufacturers andconsumers has been quite different.

“Relative prices of all international-ly traded goods increase with dollardepreciation. U.S. producers of thesegoods gain, but all U.S. buyers areharmed,” says Thomas Grennes, a col-league of Walden’s at N.C. State. “Forexample, U.S. producers of steel gainfrom more expensive imported steel,but U.S. makers of automobiles and allusers of steel are harmed because theircosts increase.” RF


Bivens, Josh. “The Benefits of the Dollar’s Decline.” EconomicPolicy Institute Briefing Paper no. 140, July 24, 2003.

Gramlich, Edward. “The Importance of Raising National Savings.”Remarks Delivered at Dickinson College, March 2, 2005.

Obstfeld, Maurice, and Kenneth Rogoff. “The Unsustainable U.S.Current Account Position Revisited.” National Bureau ofEconomic Research Working Paper no. 10869, October 2004.

“The Disappearing Dollar.” The Economist, December 4, 2004, p. 9


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Tucked among the ridges and val-leys of West Virginia, on landonce stripped for mineral

wealth, sits the biggest stash of finger-print data in the world. The FederalBureau of Investigation’s CriminalJustice Information Services Division(CJIS) is 10 years old, employs morethan 2,300 people, and forms the rootof a new economic identity for WestVirginia — biometrics.

The CJIS center has spawned a bio-metrics cluster. From certification labsto technology parks to technologytransfer groups, the industry is takinghold, according to Tom Witt, directorof the West Virginia University Bureauof Business and Economics. “The indi-cation we have nationally is that this isa center for biometrics. We’re on themap, the radar screen.”

Biometrics uses physical traits todetermine and verify identity, and as aresult, speed transaction time. A quickfingerprint scan identifies you at asupermarket counter so there’s no fum-bling for credit cards. Or perhaps youenter the workplace by staring into amachine that scans the unique patternof your retina.

The payoff could be big as the bio-metrics business grows along withnational anxiety over security and iden-tity fraud. An industry association, theInternational Biometric Group (IBG),predicts revenues will quadruple in thenext four years, from $1.2 billion in2004 to $4.6 billion in 2008.

Corporations such as defense giantLockheed Martin maintain a mountainpresence with about 250 employees inthe region anchored by the FBI. WestVirginia has built on this biometricsbase with the goal of transforming themanufacturing and mining mentalityinto a technology focus. To capitalize onthe CJIS center, the state is

pumping money into university researchfunds and the state’s venture capitalfund. West Virginia is also cultivatingits most valued resource — people.

Alan Viars is the kind of knowledgeworker West Virginia covets. He is a1999 graduate of West VirginiaUniversity, with master’s degrees incomputer science and business admin-istration. Viars works in Clarksburg as acontractor at the U.S. Department ofDefense’s Biometrics Fusion Center,the hub of defense biometrics research,testing, and evaluation. The center,located on Main Street among vacantstorefronts and next door to theOrdinary Restaurant and Pub, is onlythree and a half hours from Viars’hometown of Comfort, near the CoalRiver in Boone County. But technolog-ically, it’s light years away.

“I was offered a job and it happenedto be involved with biometrics, so Ipicked it up after college,” he explains ofhis career path. Viars, who hails from afamily of entrepreneurs, works ondeveloping data-sharing software,among other tasks. “I do a lot of pilotsto make sure things go well.” He sees theindustry, in particular the fusion center,as a permanent outcropping among theWest Virginia hills. “I can tell you that Idon’t think this place will ever go away.”In fact, a new home for the fusion cen-ter is planned on the FBI grounds with aprojected 2006 construction start date.Currently, the fusion center employsabout 100 people, many of them con-tractors. There are 150 to 175 jobs slatedfor the new location.

Viars heads Viametrica, a fledglingspin-off from West Virginia-bred TMCTechnologies, started by native WadeLinger. Lockheed Martin, with help inbiometric expertise from TMC,recently won a five-year, $25 millioncontract to work on the Automated

IDENTITY BUSINESSBY BET TY JOYCE NASH

Biometrics Cluster Sharpens West Virginia’s Economic Image

TMC Technologies’ Alan Viars assesses digital fingerprint collection systems at the

Biometrics Fusion Center in Clarksburg, W.Va.

THE



Biometric Identification System(ABIS) to store and search fingerprintscollected worldwide by the DefenseDepartment. The system will be able tosearch the database of arrestees main-tained by CJIS, a big step forward.

CJIS, the fusion center, private tech-nology firms, and a variety of state andfederal institutions comprise a technolo-gy trail in the north central part of thestate that runs along Interstate 79 fromClarksburg to Morgantown, home ofWest Virginia University (WVU). It alsostretches west along Interstate 64 toinclude Marshall University and itsforensics center.

Biometrics has become almost ahousehold word around this region.Employees at the Biometrics FusionCenter, for example, spend 10 percent oftheir time fanning out into the commu-nity to offer programs. High schoolsencourage students to explore biomet-rics, and the fusion center offers intern-ships for college students. The CJISfacility likewise reaches out. There areschool children in West Virginia whohave their fingers scanned to deductlunch money from accounts, while somestudents at WVU gain access to dormsvia hand readers.

Reclaim Land, Claim OpportunityOnce the CJIS facility cranked up,West Virginia closed in on its plan for abiometrics cluster. West Virginia’seconomy historically depended on nat-ural resource extraction and heavymanufacturing, both now declining.That left West Virginia’s per-capitaincome at 78 percent of the nationalaverage in 2003, 49th among the states,and its young people bound for oppor-tunities elsewhere.

Efforts by U.S. Sen. Robert Byrd,D-W.Va., brought the FBI division to986 acres of reclaimed strip mines nearClarksburg. It opened in 1995 and itseffects were immediate. Between 1992and 1998, the average annual employ-ment growth rate in the three-countyarea that includes Clarksburg rose by3.16 percent compared to the state-wide change of 1.7 percent.

Today, CJIS employs about 2,350

people in jobs ranging from statisti-cians to mechanical engineers to finger-print readers, among others. Lisa Stout,an arts and information specialistthere, has worked for the division since1999. She grew up here and is gratefulfor employment options that allow herto stay close to family as she raises fourchildren.

In 1999, CJIS launched its automat-ed fingerprint identification system.Response time for identifying criminalsubmissions dropped from weeks toless than two hours. CJIS stores 48 mil-lion sets of arrestee fingerprints, theoldest and most widely used biometric.This database is critical in identifyingterrorist suspects; it is linked to the U.S. Department of Defense’sAutomated Biometric IdentificationSystem to check fingerprints ofdetainees, prisoners, or suspected terrorists.

The area’s institutions have attract-ed contractors from international firmsand mountain startups, many workingon federally funded projects. For exam-ple, Computer Sciences Corp. (CSC) ofEl Segundo, Calif., obtained a four-year,$52 million contract to support theBiometrics Fusion Center inClarksburg. CSC will do it with thehelp of home-grown businesses such asTMC as well as WVU and the WestVirginia High Tech Foundation.

“Obviously in light of what hap-pened Sept. 11, many people across theworld all of a sudden discovered bio-metrics,” notes Jamie Gaucher of theWest Virginia Development Office.“We were ahead of the curve. That gaveus a boost and gained the state a greatdeal of recognition.”

Michael Yura, senior vice president of the nonprofit National BiometricSecurity Project (NBSP), says WVU’sbiometrics and forensic identificationmajors were “simmering on the backburner until 9/11, and then moved ontothe front burner on high.” The NBSP’scenter in Morgantown develops stan-dards, tests, and evaluates biometrictechnologies. WVU began its forensicidentification and biometrics majors in1997, and serves about 1,000 studentstoday. The FBI approached Yura about

creating the majors because it neededtrained employees.

“When I see an increase in enroll-ment at the state’s largest educationalinstitution within this field, I think ofthat as a resource,” Gaucher says, addingthat if a firm wants to find people with aset of skills within the biometrics indus-try, West Virginia can supply them.

Tom Witt, the director of theBureau of Business and EconomicResearch at WVU, says the growth infederal agencies and associated con-tractors working with identificationtechnologies is dramatic.

“We came up with lists in theClarksburg-Morgantown area — CSC,Galaxy Global, Azimuth, Lockheed —as examples of firms we know have atleast a portion of their work in biomet-rics. Match that with efforts at the uni-versity and other initiatives within theinstitution and you really see that it’s acritical mass.” Witt says that it’s trickyto calculate numbers of biometricsemployees because of the overlappingskills and duties in this rather hybridbusiness that is part computer science,part engineering, with some bio-sci-ences thrown in as well.

TMC founder Wade Lingerreturned to his native state in 1992 toopen an office for his then-employerManTech International Corp., whichworked on U.S. Navy contracts. Thecompany wanted a piece of the actionbubbling up in the wake of plans tolocate the FBI’s CJIS division. In 1996,Linger formed his own firm. TMC’sfirst biometrics work related to locat-ing missing children through facialrecognition. TMC, which expects 2005revenues of between $10 million and$12 million over 2004’s $9 million, hasendowed a biometrics scholarship atWVU. Biometrics has migrated intothe mainstream, Linger says.

“It’s gone from a fringe thing, withsome real dedicated geeky types thatplay in it and come up with stuff thatsometimes works and sometimes ishype — it’s gone from that to some-thing that’s a very serious core technol-ogy that’s going to be at the core ofsome important systems, like financialsystems and criminal justice and a lot of

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stuff that the military is doing, such asrefugee identification,” he says.

The Human EquationIdentity can be verified through posses-sion (a card, key, or token), knowledge,(personal identification number orpassword) or existence (physical traitssuch as fingerprints, iris patterns, handgeometry, or facial characteristics).Biometrics ratchets the identity busi-ness up a couple of notches. It trans-forms physical characteristics intocodes that can be matched against adatabase to verify identity. The idea is to make sure you are who you say you are.

Fingerprints, the oldest and mostcommon biometric, have been used inidentifying criminals for at least 100years. In England in 1902, fingerprintshelped convict someone of murder forthe first time. In the 1920s, the U.S.Federal Bureau of Investigation becamethe repository for fingerprint data.

Multiple, complicated passwords —a pet’s name or a great uncle’s cousin’sbrother with the strange first name —are the norm these days in the work-place. But some firms are already get-ting more sophisticated with fingerscans or iris recognition. At theBiometrics Fusion Center, for example,a very perfect female voice directs

employees to “Please, move forward a little” or “Please, move back a little”so that the eye lines up with a wall-mounted iris pattern reader. Iris pat-tern recognition devices comprisedabout 9 percent of the market in 2004.

Science-fiction fans know voicerecognition from 2001: A Space Odyssey.Today, voice recognition accounts forsome 6 percent of total biometrics sales,according to IBG’s Biometrics Marketand Industry Report 2004-2008. StarTrek II used scanners to allow CaptainKirk access to the Genesis Project file.All that — and more — is reality today.Bank of America uses some palm scan-ners to admit customers to safetydeposit boxes.

Security measures mandated byCongress have beefed up the govern-ment spending and propelled biomet-rics forward. For example, the U.S.Visitor and Immigrant Status IndicatorTechnology (US-VISIT) program startsabroad, where consular offices issuevisas, collect biometrics (digital fingerscans and photographs), and checkthem against a database of knowncriminals and suspected terrorists.When the visitor arrives at an entrycheck in the United States, their bio-metrics — digital finger scans — matchthe visitor to the same person whoreceived the visa.

By the end of 2005, US-VISIT willoperate at all ports. The U.S. govern-ment has set October 2005 as the dead-line for requiring people from some 27countries (Visa Waiver Programnations) to develop machine readablepassports carrying biometric informa-tion on a chip.

The International Civil AviationOrganization established facial mappingas the global biometric standard for the e-passports. And electronic U.S.passports are in the testing phase. A voluntary identification tool for frequent travelers is under way at select-ed airports, using biometric identifiers.

Hand geometry readers already areused at some workplaces not only toverify identity but also to replace thetime clock. Face recognition, estimatedto be about 12 percent of sales, usesvideo cameras to photograph and digi-

tally map points across a face to searcha database for a match to stored images.

Though the bugs in biometrics sys-tems are still being worked out, alongwith standards, the industry is comingof age, especially as the U.S.Department of Defense and HomelandSecurity sink billions into security. Thedirector of the U.S. Department ofDefense’s Biometrics ManagementOffice, the policy arm of the fusion cen-ter located in Clarksburg, is JohnWoodward. He studied biometrics foralmost a decade. The way to leveragebiometrics’ power as a tool for defense,Woodward says, is to be able to searchthe biometric information against asmany databases as possible.

“People say finding a terrorist is likefinding a needle in a haystack. You cando exactly that. You can search to findthat needle in a haystack, but to dothat, searching data has to be in aninteroperable format,” Woodward says.And that’s where the ABIS projectemerges. “We’re trying to take biomet-ric data that the military collects fromenemy combatants, detainees, etc., andcollect that data, store it, and search itto see if we can link to the person’s pre-vious identities or past criminalattacks,” he explains.

Cluster EffectsWoodward believes the fusion center’spresence in West Virginia will behealthy.

“The global war on terrorism is sadlynot going away anytime soon,” he says.“I think you’ll see growth at our WestVirginia office.”

North central West Virginia’s geo-graphic concentration of inter-connected industries, many of which dobiometrics work, is based on the FBICJIS division and a wide array of gov-ernment entities. Some of those includethe National Institute for OccupationalHealth and Safety, the Center ofBiomedical Research Excellence, theNASA Independent Verification andValidation Facility, and the NASA WestVirginia Space Grant Consortium.

Economists who study clusters saythat even as the global economy andtechnology have erased some of the


A soldier enrolls her iris with an iris reader at the Biometrics Fusion Center.


needs for companies in a similar busi-ness to work in proximity, there arecompelling reasons to do so.

Michael Porter of HarvardUniversity writes: “Even as old reasonsfor clustering have diminished inimportance with globalization, newinfluences of clusters on competitionhave taken on growing importance inan increasingly complex, knowledge-based, and dynamic economy.”

In short, clusters foster innovation.And to promote the cluster, WVU hasbeefed up its research funding from $60million in 1998 to $140 million in 2004,according to Russ Lorince, director ofeconomic development for WVU. Thegoal is to reach $200 million by 2010.And disclosures have ramped up asresearchers move closer to patents.

The economy in the region is diverse— traditional mining and manufactur-ing jobs represent about 8 percent ofthe work force and health care is themajor employer. The region’s workforce is educated — with 21 percenthaving bachelor’s degrees compared to14.8 percent statewide.

Jerry Paytas of Carnegie MellonUniversity has studied clusters exten-sively. The advantage of an institutionalcluster, he notes, is stability. “The feder-al facilities aren’t going to suffer frommarket shocks,” he says. “You can stillhave shifts in political winds. In someways, those are more predictable. Withthe federal government, you can negoti-ate a transition period.”

But an institutional cluster is oftenfocused on national needs and that canlimit the benefit to the region. “Interms of making a decision, you mighttry to get some business for local firms,but they’re beholden to different crite-ria. They might have to get the lowestsupplier. Their mission is not to growyour economy.”

Still, the industry is emerging andobservers say that’s why the best is yet to come.

Biometrics Buzz Industry experts say the biometricsbuzz will get louder, as worries aboutaccess mount and as businesses get onboard and the technology gets cheap-er and more accurate. Nearly all thoseinterviewed for this article said themarket, deployment of technology,research, funding, and acceptancehad accelerated since 9/11. TheInternational Biometric Group esti-mates sales of fingerprint identifica-tion systems alone at $1.5 billion by2008, largely because of projects suchas border control, immigration,national identification cards, anddrivers’ licenses. And as public aware-ness expands, analysts expect com-mercial interests to blossom with par-ticular emphasis on managing data infinancial services and health care.

Consumer convenience will deter-mine acceptance. Some grocers,including Piggly Wiggly Carolina Co.with stores in South Carolina andcoastal Georgia, offer customers theoption of using a finger scan to access a payment choice. Shoppers first regis-ter payment options along with the fingerprint. Fifty percent of storeshoppers elected to use the scan. Thecompany’s senior vice president testedthe system last summer when he wason a boat trip.

“I was wearing swim trunks and a T-shirt. I went into the store empty-handed. No wallet, no money,” DavidSchools says. “I loaded a shopping cartwith drinks and chips and snacks, wentto the checkout, used my finger, paidfor my groceries, and was on my way.”

Biometrics technology is now livingup to the claims of the vendors, accord-

ing to IBG consultant David Ostlund.He observes that post-9/11, peoplehave the notion in their head they needto maintain security. One of the firstlarge-scale biometric deploymentsbegan in the 1980s, with hand geome-try devices at Ben Gurion Airport inTel Aviv, Israel. “They still use it.”

Off-the-shelf technologies areavailable today, with fingerprint scandevices on keyboards, Panasonic irisrecognizers, and a host of other tech-nologies on the market. And that’s gotto be good news for the industry clus-ter in West Virginia.

The industry’s intellectualresources are already on the ground inWest Virginia because of the federalinstitutions, notes Jamie Gaucher,with the West Virginia Developmentoffice. “We’re on the verge of a small-and medium-sized business explosionin biometrics.”

And that will help keep the youngpeople in the state. It may even draweducated people from other states,says Alan Viars. “I thought of leaving,”Viars says. “But I found a job duringgraduate school that involved biomet-rics. It was pretty easy for someonewith my background to fall into thebiometrics industry.” RF


A technician at the Biometrics Fusion Center tests afacial recognition system.

Paytas, Jerry, Robert Gradeck, and Lena Andrews. “Universities andthe Development of Industry Clusters.” Carnegie Mellon University,Center for Economic Development. Prepared for the EconomicDevelopment Administration, U.S. Department of Commerce, 2004.

Porter, Michael. “Location, Competition, and EconomicDevelopment: Local Clusters in a Global Economy.” Economic

Development Quarterly, February 2000, vol.14, no.1, pp. 15-34.

Woodward, John, Nicholas Orlans, and Peter Higgins. Biometrics. New York: McGraw-Hill/Osborne, 2003.

Visit www.richmondfed.org for links to relevant sites andsupplemental information.

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The way Roger Dick tells it, Bankof Stanly opened its doors onJan. 26, 1984, in the tiny hamlet

of Albemarle, N.C., about 40 miles eastof Charlotte, on the strength of littlemore than the community’s word thatit would support a small, locally ownedbank. In a town that had suddenly seentwo local banks gobbled up by largercompetitors, a handful of business lead-ers took the then-31-year-old Dickaside and asked him if he’d be interest-ed in helping them launch a new bank.

Dick was an executive of one of thebanks that was being acquired, and hequickly agreed. He drew up an offeringcircular himself, showed it to the NorthCarolina Commissioner of Banks, andgot approval to start raising money. Hesold $2 million in stock from the trunkof his car, insisting that no one holdmore than 1 percent of the outstandingshares, a notion that many observerswould consider absurd today.

Surviving for any length of time as a community bank in a rural market is no easy feat. There have been plentyof lean years, but the Bank of Stanlytoday endures and has even added aparent holding company to diversify itsinterests.

To put this accomplishment in per-spective, consider that a total of 10banks, including Stanly, were charteredin the Fifth District during 1984. Today,only the Bank of Stanly remains. Theothers were bought out or failed.

Says Dick, who serves as chief exec-utive of the bank’s parent company:“Occasionally, you get someone comingthrough saying that, for some price,you’re for sale. But if I sell the bank,

then I sell control in the capital in ourcommunity. I’m not going to sell.”

Why Community Banks MatterBank of Stanly’s status as sole FifthDistrict survivor from the Class of ’84speaks to a trend facing communitybanks nationwide. At the end of 1984,there were 14,351 banks with $1 billionor less in assets across the country.Entering 2004, that number was rough-ly halved to 7,337, according to figureskept by the Federal Deposit InsuranceCorp. (Because these figures don’t con-trol for inflation, a $1 billion bank in1984 would, in real terms, be larger thana $1 billion bank today.)

Records kept by the Fed tell a simi-lar story in the Fifth District: Of the310 banks that opened with new char-ters between 1984 and 2004, just overhalf — 171 of them — continue today asindependent banks.

The pace of new bank charteringshas followed a parallel script. In 1984,new bank openings approached 400nationwide. Since then, there havebeen ups and downs, but the generaltrend is south.

Given those trends, it seems thatcommunity banks are losing their eco-nomic place in the U.S. financial servicessystem, largely replaced by big banks,credit unions, and stand-alone mortgagebrokers that are quickly filling the nich-es once occupied exclusively by home-grown banking institutions. And sincecommunity banks now hold only a smallfraction of the country’s total financialassets, they appear to create little sys-temic risk to the U.S. financial system.All this raises the following question: Do

community banks matter anymore? Notsurprisingly, community bankers areunequivocal about their utility, and pointto the importance of having close rela-tionships with their customers, especial-ly when it comes to making lending deci-sions. At the Bank of Stanly, Dick calls it“financial services on a human scale.”

Thanks to a plugged-in board ofdirectors, community banks often are privy to personal information about clients that big banks either wouldn’t know or wouldn’t factor in lending deci-sions. “We can get more informationwithout just relying on financial dataand still make a good decision about acredit because we have a more holisticinsight into clients,” Dick says.

William Keeton, an economist at theFederal Reserve Bank of Kansas City,has studied the role of communitybanks and concludes that they remainviable and worthy of regulatory interest— though certainly not on the scalethey did 20 years ago. In particular,community banks are still significant inmany rural and some midsized urbansettings, as well as in the crucial realm ofsmall-business lending, Keeton says.The sort of personal lending relation-ships described by Bank of Stanly’sDick are crucial to understanding whycommunity banks matter.

“It’s clear to me there’s going to bedemand on the lending side for thekinds of services community banksprovide,” Keeton says. “Smaller bankshave an advantage collecting informa-tion. They know the market, they havecontacts in the community, and they’rein a position to assess the borrower. Idon’t see that advantage going away.”

A decade ago, small banks were being gobbled up by big banks, but those days seem to be over. What are they doing now?BY DOUG CAMPBELL

COMMUNITYBANKING



That “advantage” is the reason why94 percent of this nation’s banks remain“community” banks, defined as havingfewer than $1 billion in assets. On theflip side, community banks, as youmight expect, are losing the battle formarket share. Nationwide, communitybank branches held 17.6 percent of alldeposits in 2002, according to a Fedstudy, down from 29.2 percent in 1984.And in the Fifth District, the 2002 figure was even lower at 16.4 percent.

Acquisition TargetsThe ability of small banks to carve outeffective customer relationships haslong persuaded some displaced bankingexecutives to try their hands at openingcommunity banks. Even amid the gen-eral decline in numbers of communitybanks, there have been several yearswhen new banks sprouted in large num-bers, particularly when the economyhas been humming along. More than200 banks were chartered nationwideannually between 1987 and 1989; thoseheights were reached again in the threeyears between 1999 and 2000.

Arnold Danielson, chairman ofRockville, Md.’s, Danielson Associates,an investment bank, says the availabili-ty of capital is key in driving new bankcharters. Most new banks cater largelyto small business owners, Danielsonsays. They thrive in markets that hap-pen to be growing and are more at riskin locations where the economy is stag-nant. Investing in new banks in goodmarkets is almost always a wise move,Danielson says.

Except for one thing: A major rea-son many new banks have proven to begood investments is because they werelater bought for some multiple of theirbook value. But the days of big banksbuying small banks have largely cometo an end. Big banks have used liberalinterstate branching laws to fill in theirturfs as much as they need.

So while nearly half the banks that

opened in the Fifth District since 1984have already been acquired or failed, the bulk of that activity happened among banks opening in the 1980s andearly 1990s. Those banks that openedin the late 1990s don’t seem to have thesame exit strategy for investors thatpredecessors did.

“I made money on new banks, butI’m not enthusiastic right now. I don’tsee an exit strategy,” Danielson says.“So you just don’t have the typical buyers any longer.”

Wood Britton, an investmentbanker with The Orr Group inWinston-Salem, N.C., remembers thego-go merger years of the early- andmid-1990s. In North Carolina, therewere five formidable “midsized” banks— BB&T, Central Carolina Bank,Centura, Southern National, andUnited Carolina Bank — that frequent-ly bid on the same deals for communitybanks. But four of those five wereacquired by other banks, leaving onlyBB&T, which has transformed itselfinto a certified big bank with assets ofmore than $100 billion.

“Nowadays, if I’m going to comeinto North Carolina, buying a bankwith $500 million in assets is not usually enough to make a dent in themarketplace,” Britton says. So thenumber of interested potential buyersof banks of that size has diminished.

Community banks aiming to main-tain their attractiveness to buyersought to locate only in strong growthmarkets, Britton says. This is one reason why so many more banks arebeing bought in Florida in recent yearsthan in, say, the Carolinas.

Back to Basics: With a Few TwistsThe last bank to open in the FifthDistrict during 2004 was TriStoneCommunity Bank of Winston-Salem.While already a crowded banking environment, Winston-Salem is a relatively strong market for growth in

North Carolina. And with the 1996-opened Southern Community Bankand Trust reaching almost $1 billion inassets, TriStone organizers saw an oppor-tunity: They would build a true “com-munity” bank, now that SouthernCommunity was growing beyond thebenchmark $1 billion in assets.

Led by CEO Simpson O. Brown,organizers raised $16.5 million andopened TriStone on Nov. 30, one of 16banks chartered in the Fifth District in2004 — the highest annual total since2000’s 18. At TriStone, they are notreinventing the community bankingwheel. “We are a small business bank,”Brown says. “A lot of folks talk aboutcustomer service; we really put thatinto practice.” Unusual amenitiesinclude a fireplace and wide-screen TVwhere clients are invited to linger.

On the more pressing matter ofcompeting with larger rivals, TriStonehas allied itself with a group of commu-nity banks through which it sells loans,keeping its own risk level down whilemaking it seem to clients they can han-dle large deals.

“I think it’s a very viable strategy,”Brown says. “We’ll do what’s in the bestinterest of our shareholders, but wedidn’t build this model to sell.”

Not far down the road at Bank ofStanly, CEO Dick wants the same thingfor his bank. But even after a 20-yearrecord of durability unmatched in theFifth District, he is more cautious. LikeTriStone, Bank of Stanly has diversifiedits offerings and set up a parent compa-ny to branch out geographically.

Yet sitting in the heart of ruralNorth Carolina, where job losses in thetextile industry have been significant,does not make Dick optimistic: “Ithink the hardest period to deal with isthe one we’re in now. To achieve thatcritical mass to be competitive is verycomplicated. I wish it didn’t have tobe.” Even community banking is nolonger simple. RF

Critchfield, Tim, et al. “Community Banks: Their Recent Past,Current Performance, and Future Prospects.” FDIC BankingReview, 2004, vol. 16, nos. 3-4, pp. 1-56.

Keeton, William. “The Role of Community Banks in the U.S.Economy.” Federal Reserve Bank of Kansas City EconomicReview, Second Quarter 2003, vol. 88, no. 2, pp. 15-43.


R E A D I N G S


ECONOMICHISTORY

Washstands, Sideboards, and Parlor SuitesB Y R O B E R T L A C Y

Furniture making has a long tradition in the Piedmont regionof North Carolina. Many years

before High Point, Drexel, andThomasville became famous for furni-ture manufacturing, craftsmen in thearea provided the overwhelmingly ruralpopulace with handmade chairs, tables,and beds.

In the 1800s, exceptional cabinet-makers in the Moravian settlement ofSalem (now Winston-Salem) and inQuaker communities in Randolph andRowan counties worked wonders withwood, creating furniture pieces that arecollectors’ items today. And ThomasDay, a free African-American in ante-bellum Milton, N.C., had both theartistic talent to design fine furnitureand the business acumen to run thelargest furniture-making operation inNorth Carolina in the 1850s.

With such precedents, it’s not sur-prising that a modern, mechanized fur-niture manufacturing industry wouldtake root in North Carolina at the turnof the 20th century. There were hugetimber operations in the state. Plenty ofoak, poplar, maple, and other trees suit-able for furniture making remained tobe harvested. There were also plenty ofmen available to work in furniture facto-ries, an attractive alternative to thedrudgery of farm work during the era.

What was remarkable was just howquickly the furniture-manufacturingindustry in Piedmont North Carolinawould grow in the early decades of the20th century. By 1929, North Carolinawas among the top-five states in thenation in the production of woodenhousehold furniture. Small towns in theregion were becoming as famous for fur-niture as the more industrialized citieslike Chicago, Cincinnati, and GrandRapids, Mich. A Southern furnitureindustry had emerged in the Piedmontregion, with High Point as its center.

During its formative years, from1880 to 1930, furniture manufacturingplayed a key role in the industrializa-tion of North Carolina. Along with thetextiles and tobacco industries, the fur-niture industry would demonstratethat Southern manufacturers couldattract capital and develop the man-agement and labor skills necessary togrow and prosper.

While agriculture would continueto dominate North Carolina’s econo-my for years to come, the state wouldbenefit greatly from the economicdiversification that manufacturingoffered. As the most industrializedstate in the South, North Carolina wasconsidered a model for other Southernstates to follow in promoting industryand economic development.

The Early YearsManufacturing meant progress inNorth Carolina in the late 19th century.In the decades following Recon-struction, civic and business leaders, inalmost frenzied tones, touted theadvantages of manufacturing in creat-ing wealth and prosperity.

Lacking the resources and capital toemulate many of the successful manu-facturing operations in Northernstates, North Carolina manufacturerslooked to what natural resources theyhad and added value where they could.


Making Furnitureand Progress inNorth Carolina’sPiedmont

Early Hickory factory workers take a break to pose in 1901.

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What they had in abundance — andwhat they knew — was cotton, tobacco,and timber. They merged agriculturewith light industry, and by 1880 theindustrial revolution was under way inearnest in North Carolina. Over time,three industries — textiles, tobaccoprocessing, and furniture manufactur-ing — would become symbols ofprogress not only in North Carolina,but also in the entire South.

Large-scale, mechanized furnitureoperations first emerged in thePiedmont region in the 1880s. Amongthe earliest was the White FurnitureCompany in Mebane, organized bybrothers David and William White in1881. With a little cash and a loan from afamily friend, they began producing oakdining room tables. Known for years asthe South’s oldest maker of fine furni-ture, White Furniture would remain inMebane for more than 100 years.

Another early enterprise was theHigh Point Furniture ManufacturingCompany in High Point. It was found-ed in 1889 by Ernest A. Snow, a lumbersalesman, and local merchants JohnTate and Thomas Wrenn. The HighPoint factory was small, amounting tono more than a two-story shed accord-ing to one account, and it producedmainly wooden beds and sideboards.But it grew quickly: Total sales were$75,000 the first year and twice that thesecond.

In nearby Thomasville, manu-facturers were gaining a reputation formaking good chairs. D. S. Westmore-land operated a factory there in the1880s, and H. E. Clement founded theThomasville Manufacturing Companyin 1895. A Thomasville factory couldturn out as many as 1,500 chairs a day inthe early 1900s. A huge wooden chair,some 13 feet tall, would be erected onthe main street in Thomasville in 1922, a monument to its heritage as the “chair town of the South.”

In the early years, the principalproduct was simple oak furniture, soldprimarily in Southern markets at inex-pensive prices. Bernhardt’s furniturecompany in Lenoir sold thousands ofoak chests and tables that cost less than$4 each around the turn of the century.

A solid oak bedroom suite, consisting of a bed, dresser, and washstand, wasavailable from White Furniture for $9.A manufacturer in what is now Drexelsold a three-piece suite, with an oakbureau, washstand, and bed, for $14.50wholesale.

It was sturdy, inexpensive furnitureintended for a largely rural populationwith modest means. “People [in thestate] were dirt-poor,” notes PatriciaMarshall, curator of furnishings anddecorative arts at the North Carolina

Museum of History in Raleigh. “Theywere just getting back on their feet inthe years after Reconstruction.” Even ifNorth Carolina manufacturers couldhave produced higher-quality furniturein the early years of the industry, mostof the people in the state could not haveafforded it.

According to the U.S. CensusBureau, there were 44 furniture-manu-facturing establishments in NorthCarolina in 1900, producing $1.5 mil-lion worth of furniture. Although still


“Nobody could work a man harder or longer in a mill than heworked on the farm or his childreneither. Nobody would pay him lessthan he made there.”

— Jonathan DanielsTar Heels: APortrait of North Carolina, 1947

As industrialization began to take holdin Piedmont North Carolina in the

closing decades of the 19th century, anincreasing number of men, women andchildren went to work in textile mills,tobacco plants, or furniture factories.Many of them were just off the farm,attracted by a steady paycheck and thehope of a better life. For most, life at aNorth Carolina factory or mill would turnout to be a vast improvement over life onthe farm.

It was, without a doubt, hard work inthe new industries in the region. Workersthere put in long hours, often 70 or morehours per week. And they didn’t makemuch — as little as 40 to 50 cents per dayin the 1890s for textile workers and some-times paid in scrip, redeemable only atcompany stores.

But farming during the era seldom paidat all. Even in good years, North Carolinafarmers barely made ends meet. In badyears, when crops failed or crop prices werelow, they lost money. For most farmers, thelast few decades of the 19th century werean interminable stretch of bad years.

Crop prices generally declined in thelate 19th century as the farm sector lan-guished in a protracted depression.

Cotton, the indispensable raw materialfor the cotton textile industry, fellsharply in price — from 15 cents perpound in the early 1870s to 6 cents perpound in the latter half of the 1890s.Most farmers lost money growing cotton,even as mill owners profited and the cot-ton textile industry flourished. Usually indebt, with farm land mortgaged, manyNorth Carolina farmers lost their farmsas well.

Of course, many of North Carolina’sfarmers never had their own land to losein the first place. In 1880, more than athird of the state’s farms were operatedby tenants, who worked someone else’sland and paid the landowner when thecrops came in. Some paid in cash whileothers were sharecroppers who agreed toshare the harvest with landowners. Thevast majority of tenant farmers livedimpoverished lives; many suffered physi-cal maladies from improper diets andpoor health care.

With miserable conditions in the agri-cultural sector, news of a mill or factoryopening in the region was cause for cele-bration. Tenant farmers in particularflocked to the expanding industries in thestate. Men, women, and even childrenfound employment there. (About a quar-ter of textile mill workers in 1900 werechildren.) While the work was drudgeryand the factory floor often hot and noisy,they stayed with it.

Once they left, few mill or factoryworkers ever returned to full-time farming.

— ROBERT LACY

Off the Farm


small compared to the textiles, tobacco,and lumber industries in the state, thefurniture industry was firmly estab-lished at the turn of the century andgrowing fast.

Growth: 1900 to 1929North Carolina’s furniture industrywould realize remarkable success inthe early decades of the 20th century.The value of furniture manufacturedin the state rose from $1.5 million in1900 to $56.7 million in 1929, thehighest in the South and sixth amongstates nationwide. North Carolinamanufacturers excelled in the pro-

duction of household furniture; theyranked first in wooden dining roomand bedroom furniture and second inwooden kitchen furniture by thattime.

What accounted for their success?Proximity to suitable timber certainlyhelped. Oak, yellow poplar, maple,chestnut, and other hardwoods well-suited for furniture grew in abundancein North Carolina and nearby states.Oak, still the most widely used woodfor furniture in the South in the early1900s, came primarily from NorthCarolina and eastern Tennessee.

Proximity to timber helped hold

raw material prices down; in 1929, the average cost of lumber used formaking furniture was $40.78 per 1,000feet in North Carolina. In contrast,Illinois manufacturers paid $72.68while those in New York paid $71.77.With materials costs accounting forabout 45 percent of the total costs ofmanufacturing medium-quality furni-ture, Piedmont furniture manufactur-ers had secured a substantial costadvantage over Northern andMidwestern manufacturers.

North Carolina furniture manu-facturers also paid lower wages thanmanufacturers in the North. The aver-


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Johann Belo. Mordica Collins. John Swisegood. Thomas Day. Unfamiliarnames to most of us, but they were all master cabinetmakers in the1800s. In small shops in the backcountry of North Carolina, theyproduced the finest furniture around.

Many of the most accomplished furniture makers in the regionhailed from the Moravian community of Salem. The Moravians werea religious group that settled in North Carolina in the 1750s. Largelyof German descent, they built furniture notable for solidity, simplicityof design, and careful construction.The Moravians believed that wood-working, pottery making, and metalcrafting, like other daily routines, wereways of serving God; and manymembers of the Salem communitybecame expert cabinetmakers, potters,and metalworkers in the 19th century.

“The Moravians were finecraftsmen in the backwoods,” notesPatricia Marshall of the North CarolinaMuseum of History. “They had a uniquestyle. There was also somesophistication to their work, with theiruse of wood inlays.”

Cabinetmakers were a vital part ofthe Moravian community because theycould build household necessities that would otherwise have to befreighted in over land to the somewhat isolated town of Salem. Inaddition to such items as chairs, tables, beds, chests of drawers, anddesks, they constructed doors and window sashes for houses. JohannBelo, who operated a shop in Salem from 1806 to 1827, was but oneof many Moravian cabinetmakers of the period.

About 20 miles to the south of Salem, in the Abbotts Creek areaof what is currently Davidson County, N.C., another group of mastercraftsmen plied their trade. The most notable of these was JohnSwisegood. He learned cabinetmaking and joinery while apprenticed

to master craftsman Mordica Collins. By 1820, he was operating his ownshop as a master cabinetmaker. He made desks, chests, cupboards,and chests of drawers, some of which were signed and thus can beeasily attributed. A Swisegood piece can bring thousands of dollars atauction today.

In the small town of Milton, near the Virginia border, lived ThomasDay, one of the most impressive of North Carolina’s 19th centurycabinetmakers. Born in Dinwiddie County, Va., in 1801, he was a free

African-American who moved to Miltonin the 1820s. Along with bureaus, tables,chairs, and beds, he built householdfixtures such as fireplace mantles andstair railings.

Thomas Day had a reputation forinnovative design, careful construction,and use of mahogany veneers. “He cameup with designs of his own as well asusing pattern books and styles of theperiod,” says Marshall. “Other furnituremakers gravitated to what he was doingand copied him.”

Families in many of the plantationhomes in the region, as well as in thegovernor’s mansion in Raleigh, had

furniture or millwork made by Day’s shop.By 1850, Day’s furniture-making business was the largest in NorthCarolina. His shop employed free black, white, and slave laborers. Hewas one of only a handful of North Carolina furniture makers usingsteam-powered tools in 1850 and thus one of the earliest to beginthe transition to a fully industrial production process.

Laurel Sneed, executive director of the Thomas Day EducationProject, notes that Day is considered a major figure of the antebellumera. “He was quite active as an entrepreneur and left behind amazingfurniture and interior woodwork. He certainly challenges stereotypesabout African-Americans of the period.” — ROBERT LACY

Master Cabinetmakers in the 19th Century: Fine Furniture from the Carolina Backcountry

Advertisement from the March 1, 1827 issue of The Milton Gazette.


age wage in the furniture-manufactur-ing industry in North Carolina in 1929was 33 cents per hour. In major furni-ture-producing states in the North,wages were generally much higher: 57cents per hour in New York, 56 centsper hour in Michigan, and 47 cents perhour in Pennsylvania.

In addition to receiving lower wagesthan their counterparts in Northernstates, North Carolina furniture work-ers tended to work longer hours.Piedmont furniture workers in the1920s typically worked 50 to 55 hoursper week. A 40-hour workweek wouldn’tbecome standard until the 1930s.

But compared to farming, the alter-native for most North Carolina factoryworkers, a furniture factory job was astep up. Most North Carolina farmerslived hand to mouth on small farms offewer than 100 acres. Many farmersduring the period didn’t even own theland they farmed; about 45 percent ofNorth Carolina farms in 1925 wereoperated by tenants. Just about any jobat a furniture factory was better than ahard scrabbled life on the farm.

The existence of a grid of railroadtracks that provided reliable freighttransportation services in the Piedmontregion also spurred the industry’sgrowth. The rail system enabled timberto be hauled to factories and bulky furniture to be transported throughoutthe region at reasonable costs. Therewere direct routes to markets in theNortheast and South, as well as to amajor seaport at Norfolk, Va., where furniture could be shipped abroad. High Point, Hickory, Thomasville,Lenoir, and Morganton were among theNorth Carolina towns with furniturefactories built along the railroad tracks.

Lower costs for labor and raw mate-

rials and easy access to markets allowedNorth Carolina manufacturers tosteadily gain market share from com-petitors in the North and Midwest. Inaddition, they benefited from anexpanding market for furniture. Risingincomes, a growing middle class, and ahome-building boom after World War Ihelped fuel prosperity in the NorthCarolina furniture industry in the1920s. Output from North Carolinafactories nearly doubled during thedecade. New factories were built andimproved production methods imple-mented, in some cases emulating mass-production techniques used in theautomobile industry.

By 1929, more than 16,000 peoplewere at work making furniture inNorth Carolina, up from fewer than2,000 in 1900. Value added in the fur-niture industry in 1929 amounted to$27 million, well below that of thetobacco or textiles industries, but highenough to place furniture among theleading manufacturing industries inthe state.

Economic ProgressIn 1930, only a generation removed fromthe nascent industry of the turn of thecentury, North Carolina furniture man-ufacturers had every right to be proud ofwhat had been accomplished. Their fac-tories produced more furniture thanthose in any other state in the South,and they had proven to be worthy rivalsto furniture makers in the North andMidwest. And they would continue togrow and prosper. While the GreatDepression caused furniture demand todrop precipitously in the early 1930s —retail furniture sales in the nationdeclined by 63 percent between 1929and 1933 — population growth and

rising incomes in the 1940s and after-ward fostered long-term growth in theindustry.

Fifty-five hour workweeks and 33 cents per hour earnings may not sound like much progress today. ButNorth Carolina’s furniture industryhelped lead the way in the industrialdevelopment of the South in the earlydecades of the 20th century. The RipVan Winkle state, as it was sometimescalled in the 1800s for its backwardnessand seeming indifference to social andeducational reforms, was at the fore-front of the economic progress thatwould eventually bring higher stan-dards of living to the South. RF


Bivins, John, Jr., and Paula Welshimer. Moravian Decorative Arts inNorth Carolina: An Introduction to the Old Salem Collection.Winston-Salem, N.C.: Old Salem, Incorporated, 1981.

Hobbs, S. Huntington, Jr. North Carolina: An Economic and SocialProfile. Chapel Hill, N.C.: University of North Carolina Press, 1958.

Lacy, Robert. “Whither North Carolina FurnitureManufacturing?” Federal Reserve Bank of Richmond Working Paper no. 04-07, September 2004.

Lefler, Hugh T., and Albert R. Newsome. North Carolina: The History of a Southern State. Chapel Hill, N.C.: University of North Carolina Press, 1963.

Lemert, Ben F. “Furniture Industry of the Southern AppalachianPiedmont.” Economic Geography, April 1934, vol. 10, no. 2, pp. 183-199.


R E A D I N G S

North Carolina Factory-Produced Furniture(1890 and 1900)

1890 1900 Establishments 6 44Wage Earners 152 1,759Value of Product $159,000 $1,547,305Capital $126,350 $1,023,374

SOURCE: U.S. Census Bureau, 1900

Wood Used in FurnitureManufacturing(1909 to 1913)

PercentageOak 64.0Gum (red, tupelo, and black) 12.2Yellow poplar 10.6Southern yellow pine 4.4Chestnut 2.6Maple 1.4All other woods 4.8

SOURCE: C.F. Korstian. The Economic Development of theFurniture Industry of the South and Its FutureDependence Upon Forestry. Raleigh: North CarolinaDepartment of Conservation and Development, 1926


RF: Your early work focused on topics that were fairlyconventional. How did your work progress into areas,such as strategic bargaining, that largely had beenbeyond the scope of economists?

Schelling: In 1948, I had just finished my coursework forthe Ph.D. at Harvard, and a friend of mine called fromWashington. He was working on the Marshall Plan and saidthat he had an opportunity to go to Paris but he couldn’tleave until he had a replacement. So he asked me if I wouldlike to replace him. I said sure.

Eventually, I went to Europe as part of this assignmentand worked mainly on negotiations for the EuropeanPayments Union. Then, Averell Harriman, who had beenhead of the Paris office, went to the White House to bePresident Truman’s foreign policy advisor. Harriman askedmy boss to go with him, who in turn asked me a few monthslater to join him. In 1951, the foreign aid program was shift-ed to the Mutual Security Program, with Harriman asdirector, in the Executive Office of the President. I movedthere, and stayed through the first nine months of theEisenhower administration. So when I left, I had spent fiveyears in the foreign aid bureaus, largely working on negoti-ations. That, I believe, was what focused my attention onthe type of issues that showed up in The Strategy of Conflict.

RF: One of the more famous bargaining situations thatyou propose in The Strategy of Conflict involves a prob-lem in which communication is incomplete or impossi-ble — the game where two strangers are told to meet inNew York City but have not communicated with eachother about the meeting place. What does this game tellus about bargaining? And what, if any, are the policyimplications?

Schelling: That little exercise, which I designed to deter-mine if people could coordinate without any communica-tion, became fairly famous and now I am usually identifiedas the originator of the idea of “focal points.” My argu-ment was that in overt negotiations something is requiredto get people to arrive at a common expectation of an out-come. And the ability to reach such a conclusion withoutcommunication suggested to me that there was a psycho-logical phenomenon, even in explicit negotiations, whichmay work to focus bargainers eventually on that commonlyexpected outcome. By understanding that, I thought, wemay be able to more easily facilitate policy negotiationsover such matters as what would be an appropriate divisionof the spoils, an appropriate division of labor, and so forth.


INTERVIEW

Thomas Schelling

Editor’s Note: This is an abbreviated version of RF’s con-versation with Thomas Schelling. For the full interview, go toour Web site: www.richmondfed.org.

Thomas Schelling’s early research was common farefor economists in the 1950s. The quality of the workmay have been higher than most, but the topicswere relatively mundane. His first two books weretitled simply National Income Behavior andInternational Economics. But his interests extendedbeyond the traditional confines of the discipline, apoint that was made clear with the publication ofThe Strategy of Conflict in 1960. In it, he used thetools of economics to illuminate important issuesin international relations, while making significantcontributions to game theory and laying the ground-work for later research in experimental economics.

Schelling has continued to publish on militarystrategy and arms control throughout his career,but his work has led him to a number of otherseemingly disparate issues, such as racial segrega-tion, organized crime, and environmental policy. Ineach case, he has been able to generate originalinsights from ordinary observation. As his long-time colleague Richard Zeckhauser has written,Schelling “thinks about the essence of phenomena.In scanning everyday behavior, he sees patterns andparadoxes that others overlook.”

Schelling spent most of his career at HarvardUniversity, before joining the faculty of theUniversity of Maryland in 1990. He is a past presi-dent of the American Economic Association andrecently worked with other distinguished econo-mists on the Copenhagen Consensus, a projectdesigned to prioritize the largest social problemsfacing the world. Aaron Steelman interviewedSchelling at his home in Bethesda, Md., onFebruary 7, 2005.


RF: What were the respons-es when you originally posedthis question to people?

Schelling: When I first askedthat question, way back in the1950s, I was teaching at Yale.A lot of the people to whom Isent the questionnaire werestudents, and a large share ofthem responded: under theclock at the information deskat Grand Central Station.That was because in the 1950smost of the male students inNew England were at men’scolleges and most of thefemale students were atwomen’s colleges. So if youhad a date, you needed a placeto meet, and instead of meet-ing in, say, New Haven, youwould meet in New York.And, of course, all trains wentto Grand Central Station, so you would meet at the infor-mation desk. Now when I try it on students, they almostnever give that response.

Some cities have more obvious focal points than others.For instance, if I asked people where would you meet inParis, they probably would have notrouble. Most would go to the EiffelTower. But in other cities, it’s not soclear.

The question first occurred tome while I was driving across coun-try with two college friends. Wewere going from San Diego to NewHampshire and back, and campingalong the way. We stopped in SanAntonio and one of the other twoguys got out and bought somepeanut butter and crackers. Whilehe was gone, a police officer made me move on, andbecause of the one-way streets, it took me about 10 min-utes to get back to where I dropped him off, and he wasn’tthere. I kept circling around and eventually we found eachother. But we realized that this could happen to us in anycity, and we should come up with a plan about how to meetif we got separated.

We spent the whole afternoon thinking about it individ-ually, but not talking about it, and that evening around thecampfire we compared notes. We all wound up in the sameplace. The criteria we used were the following: Every cityhad to have this place and there could be only one of it, youhad to be able to find it by asking any police officer or fire-man, and you had to be able to reach it by public trans-

portation. That narrowed thelist down to the town hall orthe main police station or themain post office.

Well, before we left home,we had each given our moth-ers a list of cities in which wewould look for mail, and theway you get mail when youare traveling across country isto have the letter sent to yourname, care of general deliv-ery, and it arrives at the mainpost office in that city. Thatoccurred to all three of us,and if we had to chooseamong the places that sharedthe criteria we described, themain post office seemed tobe the obvious choice.

RF: You begin many of yourpapers with examples thatare taken from everyday

life. For instance, in “Hockey Helmets, Daylight Saving,and Other Binary Choices,” you use the case of a playerfor the Boston Bruins who suffered a severe head injuryto demonstrate why some collective action problemscan be so difficult to solve — in this case, getting

hockey players to voluntarilywear helmets. Is this a con-scious strategy of yours toengage readers in what other-wise might seem like an abstractdiscussion?

Schelling: I always try to find something that I can put in the firstparagraph to make the articlesound interesting. It was just a coincidence that the hockey playerhad been hit in the head and that

I had noticed it. It was a good example of a scenario in whicheveryone might wish to be compelled to do something thatthey wouldn’t do on their own individually. So I think that hasbeen part of my style. I wrote a textbook in international eco-nomics that had about a dozen policy chapters. I tried to havethe first page of every chapter present an interesting puzzle orphenomenon that would get the interest of the readers.

RF: You have written that the “ordinary human being is sometimes … not a single rational individual. Some of us for some decisions are more like a small collectiv-ity than like the textbook consumer.” Could you explain what you mean by this, perhaps through a fewexamples?


PHOT

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I consider myself inthe rational-choice

school, absolutely. ButI am more interested

in the exceptions thanmany other economists.


Schelling: I started working on that subject in the 1970swhen I was asked to join a committee of the NationalAcademy of Sciences on substance abuse and habitualbehavior. I was the only economist there. Everyone else wasa specialist on a certain type of addictive substance such asheroin or some other health problem like obesity. It seemedto be taken for granted that if you were addicted -- whetherto heroin or alcohol or nicotine — there wasn’t much youcould do for yourself. I argued that this was not the case,and gave a number of examples of ways people can helpthemselves avoid relapse.

For instance, one person tried to show how addictiveheroin was by pointing out that many former users, eventhose who had avoided heroin for a long time, would belikely to use the drug again if they were to hang out with thepeople they used to shoot up with or even if they listened tothe same music that they played when they used heroin inthe past. I pointed out that there was some instructivematerial right there. Don’t associate with the same people.Don’t listen to the same music. And if the place where youused to use heroin is on your way to work, find a differentroute. So even though those people may be inclined to useheroin again, there were clearly some ways in which theycould help prevent themselves from having a relapse.

The more I thought about this issue, the more I beganto conclude that a lot of people have something like twoselves — one that desperately wants to drink and one thatdesperately wants to stay sober because drinking is ruininghis life and his family. It’s as if those people have two differ-ent core value systems. Usually only one is prominent at agiven time, and people may try to make sure that the rightvalue system attains permanence by taking precautions thatwill avoid stimulating the other value system.

RF: Some have called you a “dissenter” from mainstreameconomics. But it seems to me that this is true only inso-far as it concerns topics of inquiry. On methodologicalissues, you don’t seem as willing to abandon some of thecore assumptions of neoclassical economics as, say, thosepeople who call themselves “behavioral economists.” Doyou think that this is a fair characterization?

Schelling: This is something that I talk about a lot. I claimthat we couldn’t do without rational choice. But we don’texpect rational choice from a child or an Alzheimer’s patientor someone suffering from shock. We will better understandthe uses and limits of rational choice if we better understandthose exceptions. I use the example of the magnetic compass.It’s usually a wonderful way to determine which directionnorth is. But if you are anywhere near the actual north mag-netic pole, the compass could point in any direction, evensouth. The same is true with rational choice. It is a wonderfultool if used when appropriate, but it may not work all thetime. So I consider myself in the rational-choice school,absolutely. But I am more interested in the exceptions thanmany other economists tend to be.

As for the behavioralist critique of neoclassical economics, Iwould conjecture that if you walked into a classroom where abehavioralist is teaching microeconomics, that person wouldteach it in a straight, standard fashion. It’s something that youhave to master — you can’t do without it. For instance, if a studentwere to ask about the effect of a gasoline tax on driving behavior,the response would likely be that such a tax will tend to lower con-sumption of gasoline and/or increase the desirability of more fuelefficient cars. That’s just straight neoclassical economics.

More generally, I think that when a new idea develops, it isimportant that the enthusiasts are given free rein to exploreand perhaps even exaggerate that idea. Once it catches on andbecomes respectable, then it’s time to become more critical.Rational choice has gone through that process, and the behav-ioralists have emerged to challenge some of its assumptions.The behavioralists have probably overstated their case, buttheir ideas are relatively new and will be critiqued as well.

I think that people like Dick Thaler and Bob Frank, who areclearly two of the most innovative behavioralist economiststoday, so much enjoy what they do that I’m not sure if they con-sciously exaggerate the role of these exceptional situations.When I read Bob Frank, I get the sense that he is passionate,almost emotional about his belief that American consumers aresuffering welfare losses because they are spending their moneytrying to avoid the discomfort of not being equal to their neigh-bors. I think he overdoes it, and I think that I have told him so.I don’t know if his answer today would be, “Of course I overdoit. I’m trying to get attention paid to something I think isimportant.” Or if he would say instead, “No, I don’t overdo it. Ireally do believe that the phenomenon is that important.” Buteven if the former is true, I would excuse that. I think that thepoint is important enough that if exaggeration will help themget it across, let them exaggerate.

RF: What is your opinion of modern game theory?

Schelling: That’s a hard one, because I don’t keep up with allthe latest work in that field. But I would like to make the fol-



lowing broad claims: Economistswho know some game theory aremuch better equipped to handle a lotof important questions than thosewho don’t. But economists who aregame theorists tend to be more inter-ested in the mathematics aspect ofthe discipline than the social sciencesaspect. Some economists of the lat-ter group are good at using their the-oretical work to examine policyissues. Still, many — and I think thisis especially true of young game the-orists — tend to think that what willmake them famous is their mathe-matical sophistication, and integrat-ing game theory with behavioralobservations somehow will detractfrom the rigor of their work.

I’ll give you an example. I had astudent at Harvard named MichaelSpence, who a few years ago won theNobel Prize. Mike wrote a fascinat-ing dissertation about market incen-tives to engage in excessive competi-tive expenditure. I was on his com-mittee, and I argued that he neededto do two things. First, summarizethe theory in 40 pages. Second, findsix to 10 realistic examples to illus-trate how the theory worked and whyit mattered. He spent much of a yeardoing that. But in the end, he pub-lished the 40-page version of his dissertation in a top-tierjournal, and used that paper as the first chapter of a book.Both of them got a lot of attention, and led to his appoint-ment to the Harvard faculty.

The reason that I advised him to take this approach was quite simple: If he didn’t, other people would and they would get credit for his work because they were able to apply it to real-world questions. I think that other economists, especially young game theorists, can learn from this example. Even very technical work often can be used in an applied manner — and this can benefit the work as well as the economist.

RF: In 1950, few people would have predicted, I think,that the Cold War would end as peacefully as it did. Forexample, it is surely notable that the conflict endedwithout the use of nuclear weapons. Why do you thinkboth sides avoided using means that would have had fair-ly certain, but catastrophic, consequences?

Schelling: I have written and lectured about this quite a bit.When I give a talk on the subject, I begin by stating, “Themost important event of the second half of the 20th centu-

ry is one that didn’t happen.” I thinkyou have to go through the historyto understand it fully. In the early1950s, it was believed that the likeli-hood of the United States usingnuclear weapons was so great thatthe Prime Minister of Great Britaincame to Washington with theexpress purpose of persuading theTruman administration not to usethem. And because the British hadbeen partners in the development ofnuclear weapons, their Parliamentthought that the Prime Ministerhad a good right to share in any deci-sion about how they would be used.

As we know, they were not used,but the Eisenhower administrationrepeatedly asserted that nuclearweapons were just like any othertype of weapon, and that they couldbe used as such. The attitude in theKennedy and Johnson administra-tions was quite different. Theybelieved that nuclear weapons were fundamentally different, andtheir statements helped to build the consensus that their use wastaboo — a consensus that may havedissuaded Nixon from using themin Vietnam.

Also, in the 1960s there was agreat fear that dozens

of countries would come to possess nuclear weapons. But the nonproliferation efforts were vastly more success-ful than most people expected. It was thought thatGermany was bound to demand them, and that theJapanese couldn’t afford to be without them. And then itwould spiral down to other countries: the Spanish, theItalians, the Swedes, the South Africans, the Brazilianswould all have nuclear weapons. The process by whichthese countries would acquire them, it was thought, wasthrough nuclear electric power — the reactors would produce enough plutonium to yield weapons. For severalreasons, that didn’t occur.

Israel’s restraint in the 1973 war was also very important,I think. Everyone knew that Golda Meir had nuclearweapons, and she had perfect military targets — twoEgyptian armies north of the Suez Canal, with no civiliansanywhere near. But she didn’t use them. Why? Well, youcould say, quite reasonably, that they didn’t want to sufferworldwide opprobrium. I think, though, that there wasprobably another reason. She knew that if she did, theIranians, the Syrians, and other enemies of Israel would like-ly acquire them and would not be reluctant to use them. Inaddition, it was not clear in the late 1970s that the Soviets


Thomas Schelling➤ Present PositionDistinguished University Professor,Department of Economics and Schoolof Public Affairs, University of Maryland

➤ Previous Faculty AppointmentsHarvard University (1958-1990) and YaleUniversity (1953-1958)

➤ Government ExperienceThe White House and Executive Officeof the President (1951-1953); EconomicCooperation Administration in Europe(1948-1950); U.S. Bureau of the Budget(1945-1946)

➤ EducationA.B., University of California at Berkeley(1944); Ph.D., Harvard University (1951)

➤ Selected PublicationsAuthor or co-author of several books,including The Strategy of Conflict (1960);Micromotives and Macrobehavior (1978); andChoice and Consequence (1984)

➤ Awards and OfficesFellow, American Academy of Arts andSciences; Member, National Academy ofSciences; Past President of the AmericanEconomic Association and EasternEconomic Association


shared the nuclear taboo. Yet, they didn’t use them in theirwar against Afghanistan — and this was also very important.

There is a possibility that nuclear weapons will be used inthe India-Pakistan dispute. But I’m not especially worriedabout that. The Indians and the Pakistanis have beeninvolved in nuclear strategic discussions in the West fordecades. They have had a long time to think about this, andhave watched the U.S.-Soviet negotiations. I think theyknow that if they were to use nuclear weapons it could easilylead to something beyond their control. So I think that by now the taboo is so firmly entrenched, that it is veryunlikely we will see nation-states use nuclear weapons. Whatwe don’t know is if that taboo holds for non-state actors. I think that it might, but I don’t hold that opinion withmuch conviction.

RF: Some policymakers and analysts have argued thatdiplomacy is much more difficult in today’s world than it was during the Cold War because there are now multiple non-state players whoseem to place less value on stabil-ity than the Soviets did. Howdoes this change the bargaininggame? How can economicsinform the current conflict withIslamic terrorists?

Schelling: One big difference isthat you simply don’t know whothe non-state actors are. We havemade a big deal out of Osama bin Laden. But we don’tknow if he is alive, and if he is alive, whether he still con-trols the money and organization in the way that he did afew years ago. Also, there are no recognized private chan-nels of communication with non-state actors. If you wantto get a message to bin Laden, you either hold a press con-ference and hope that he will hear it, or send it to himthrough a secret private channel.

Also, there is a popular notion that deterrence will notwork when you are dealing with non-state actors. But I’mnot so sure that this is the case. Consider the Taliban. Ithink that if the leaders of the Taliban had known what typeof response the attacks of Sept. 11 would produce from theUnited States, they would have tried to prevent the attacks.So I think that we should consider what we can do to alien-ate bin Laden from some of his supporters. You also need toconsider what types of weapons they are likely to use andwhat types of targets they are likely to choose. And we needto determine their objectives.

For instance, we still don’t know what the objectiveswere of the attacks on the World Trade Center, because theeffects were so widespread. It killed a lot of people. It pro-duced the largest media coverage of a terrorist attack in his-tory. It demonstrated U.S. vulnerability, while also destroy-ing a symbol of Western capitalism. And it demonstratedthe competence and some would say the bravery of the

terrorists who were willing to sacrifice themselves. Each ofthose could have been the principal objective, or therecould have been some combination of objectives. But wedon’t know for sure.

When we think about weapons, many people seem tothink that terrorists will use whatever weapon they can gettheir hands on. But consider the use of, say, smallpox from acost-benefit analysis. They could release smallpox in NewYork, Chicago, and San Francisco. But smallpox is a verydifficult disease to contain in a world of global travel, andthe United States is the country best equipped to deal withan outbreak. Releasing smallpox in the United States, then,could result in many more deaths in poor countries with rel-atively bad health systems like Indonesia and Pakistan thanin the United States. I’m not sure that would be a result theterrorists would welcome. By unleashing such widespreaddeath in the developing world — especially in places wherethey enjoy support today — they could substantially reducetheir approval and assistance from people who are now

their allies. In contrast, anthraxmight be a more attractive optionbecause it is not contagious, andits effects could be limited to theUnited States.

Also, there may be a culturalaspect to this. If releasing a non-contagious toxin in, say, a subwaystation is considered by large partsof Islamic culture to be a cowardlyway to attack your enemy, then this

could be costly to them. It could damage their support inthe same way that releasing a contagious toxin could, eventhough the effects of the actual attack would be much moredirect and localized.

RF: I would like to talk about your famous checkerboardexample as it applies to racial segregation. You have writ-ten, “A moderate urge to avoid small-minority status maycause a nearly integrated pattern to unravel, and highlysegregated neighborhoods to form.” Could you describehow this process unfolds?

Schelling: When I started thinking about this question,many American neighborhoods were either mostly white ormostly black. One possible explanation for this, of course,was rampant racism. But I was curious about how this mightemerge in a world where racism was not particularly acute,where in fact people might prefer racial diversity.

The process works basically like this. Let’s say the racialcomposition of a neighborhood is 55 percent white and 45percent black, and that the majority population in the sur-rounding areas is utterly without prejudice. Then you may geta case where more and more members of the majority groupmove in. This may be fine with the minority group for awhile. They may not mind going from being 45 percent of thepopulation to 35 percent. But at some point — say, when their


The most importantevent of the second

half of the 20thcentury is one that

didn’t happen.


part of the population is only 20 percent — then the mostsensitive members of that group will probably evacuate,reducing their percentage even further. The result is a highlysegregated neighborhood, even though this wasn’t the intentof the majority population.

I wanted to come up with an easily understandable mech-anism to explain this phenomenon that I could use in teach-ing a class. I spent several summers at the RANDCorporation, which had a good library. I looked at severalsociological journals, trying to find something I could use,but I wasn’t able to find anything suitable. So I decided Iwould have to do something myself.

One day, I was flying home from somewhere and hadnothing to read. So I passed the time by putting little “X”sand “O”s in a line, with one group representing whites andthe other representing blacks, and used the assumption thatthere was a moderate desire to avoid becoming part of a verysmall minority group. Well, it turned out that this exercisewas very hard to do on paper, because you had to keep eras-ing and starting over.

But my son had a coin collection at the time, and he had abunch of copper coins and a bunch of zinc coins. I laid themout, and then I decided that putting them in a line wasn’tgood enough. You needed more dimensions. So I arrangedthem on a checkerboard. I got my 12-year-old son to sit downat the coffee table with me, and we would move thingsaround. Soon, we got quite used to how it worked and howdifferent the results were if one group was more discriminat-ing than the other or if one group was more numerous thanthe other.

I published my results, and it got quite a bit of attention atthe time. But it wasn’t until 25 years later that I realized thatthis game had pioneered some of the work in what is called“agent-based modeling” and which is used in a variety of dis-ciplines in the social sciences. At the time I was working outthis example I didn’t realize that I was engaged in an area ofresearch that would one day have a formal name.

RF: How did you become involved with the CopenhagenConsensus and what type of policy proposals has thegroup offered?

Schelling: I don’t know precisely why I was chosen. BjornLomborg, the organizer of the project, wanted to gather agroup of economists of some reputation, and he probablyknew that I had written about the greenhouse gas issue. Sothat was probably the connection.

When the project started we had a United Nations list ofglobal problems related mostly to development and poverty.We were asked to look over that list and pick 10 that wethought would be worth pursuing. We did that, and then weasked a very distinguished person in that field to write amajor paper on the issue, along with two other people towrite critiques of the paper.

Somewhere along the way, we began to emphasize an ideathat wasn’t clear to me at the outset and that I think wasn’t

clear to many other people — namely, that this was mainly abudget priority exercise. We were supposed to do cost-bene-fit analysis. We were told that we had $50 billion to spend,and we should decide which projects would provide the mostwelfare benefit for the money.

Unfortunately, that approach had not governed our choiceof projects and had not governed the way the papers werewritten. For instance, no one really had a good idea of whatyou could do with some part of $50 billion to generate moreliberal trade. The same was true with education. The papersargued that unless you can reform the educational systems inthe big industrialized countries, more money won’t help.Similarly, it wasn’t clear to us how more money would help usprevent the spread of financial crises. So we had about fivetopics that really did not fit, and we treated many of them asnot applicable. In retrospect, I think we should have treatedclimate change in the same way.

Of those projects where we could see how the expenditureof money would help, restricting the spread of HIV andAIDS seemed like it should be at the top of the list. It is justso crucially important that we advocated spending about halfof the money on it. Then there were some projects, like mal-nutrition and malaria control, where you just got so much foryour money, that we put them near the top also. Projects toimprove sanitation also were deemed quite worthwhile.

In general, I think that the program was successful insome ways and less successful in others. And if we had it to doall over again, I think that we could do an awful lot better.

RF: How did you come to the University of Maryland?

Schelling: In the 1980s, Congress passed a law making itillegal for most businesses to have a mandatory retirementage for most employees. But they allowed colleges and uni-versities a seven-year grace period. Harvard, at the time, hadmandatory retirement at 70, and I was going to be 70 beforethe grace period expired. Well, I was in good health, felt thatthere was more research that I wanted to do, and stillenjoyed teaching. So I let it be known that I could beattracted to another university. My first preference was auniversity in Southern California, where I grew up. But thena former colleague and a very good friend of mine who wasdean of the University of Maryland’s School of PublicAffairs called, and I told him about my situation. He askedme not to accept another offer until I heard from him. Italso turned out that the chairman of the economics depart-ment had been my teaching fellow at Harvard in the 1960s.So I had two very close connections at Maryland, and I alsoknew a few other people on the faculty, like Mancur Olson.Plus, as we have discussed, much of my work is very policy-oriented, which made the Washington area pretty desirableto me. Overall, it seemed like this would be a good fit for me,so when the president of the university made me a very gen-erous offer, I accepted it. I have been at Maryland since1990. I still teach a class or two, but I am now in an emeritus position. RF



FIGHTING POVERTY IN THE U.S. AND EUROPE: A WORLD OF

DIFFERENCE

BY ALBERTO ALESINA AND EDWARD L. GLAESER

NEW YORK: OXFORD UNIVERSITY PRESS, 2004, 250 PAGES

R E V I E W E D B Y A A R O N S T E E L M A N

In 1906, the German economist Werner Sombartfamously asked, “Why is there no socialism in theUnited States?” In the century since Sombart posed

that provocative question, numerous social scientists haveoffered their own answers. Most notable is the sociologistSeymour Martin Lipset, who has spent much of his careertrying to explain what he calls “American exceptionalism.”Yet no one has been able to provide a definitive answer.

Part of the problem is multicausality. People generallyagree that there are several factors at work. But it’s notclear which factors are most important, or what combina-tion of factors provide the most reasonable answer.

In Fighting Poverty in the U.S. and Europe: A World of Dif-ference, Harvard University economists Alberto Alesina andEdward Glaeser bring the tools of modern economics tobear on a similar question: Why do European countriestypically have significantly larger welfare states than doesthe United States?

They begin their discussion with a brief recap of someof the relevant facts. Government expenditures in theUnited States are equal to roughly 30 percent of grossdomestic product (GDP), compared to about 45 percentfor continental Europe as a wholeand more than 50 percent in someindividual European states, such asSweden. Much of the difference inthe figures can be attributed toEurope’s more generous social wel-fare programs, which on net tend toshift income from the wealthy to the poor.

Economic (Non) FactorsLike their predecessors, Alesina andGlaeser find that there are multiplereasons for such cross-Atlantic dif-ferences. But somewhat to their sur-prise, they conclude that those vari-ables which economists mightexpect to lead to more redistributionof wealth do not have much explana-tory power.

For instance, one might surmise that there would bemore demand for redistribution in countries with high lev-els of pretax inequality in order to reduce the dispersion inwealth. But the United States, by any measure, has signifi-cantly greater pretax inequality than continental Europe.So if this argument were correct, we would see more redis-tribution in the United States, when in fact we see theopposite.

A similar argument is that demand for redistributioncould be determined by social mobility. Those countriesthat tend to see smaller shares of their populations moveup the income distribution over the course of their livesmight seek a more active role for the state in the economy.This argument has some empirical support. Members ofthe middle class in the United States tend to be moreupwardly mobile than the European middle class. Butwhen you look at the poorest members of society, the situ-ation is quite different. Europeans living in poverty aremore likely to improve their economic standing over timethan are the poor in the United States. As a result, Alesinaand Glaeser are “led to believe that the differencesbetween the United States and Europe are not the result ofgreater American mobility.”

Another possible economic explanation for Europe’sgreater level of income redistribution could depend on the relative efficiency of tax systems. If European tax collection produced smaller social losses, then the cost of the welfare state would be lower. Alesina and Glaeserreject this argument with the following, almost rhetori-

cal question: “Could it really be possible that the tax collectors inItaly are so much more effectivethan the American Internal RevenueService?”

Finally, the authors consider eco-nomic stability as a possible reason.The welfare state is often seen asprotecting people from suddenchanges in the economy. So youmight expect that places where eco-nomic ups and downs are more fre-quent or severe would have largerwelfare states. But the variability ofgrowth and unemployment rates isgreater in the United States than inEurope. Yet, as we have seen, theU.S. welfare state is considerably lessgenerous, making this argumentimplausible.


BOOKREVIEW

America the Unusual


Political Factors“Our examination of explanations which we labeled as purely‘economic’ has left us almost completely empty-handed,”Alesina and Glaeser conclude. They turn next to what theylabel “political” explanations — those that “emphasize thestate, the political arena, and political institutions” — andhere they find more success.

At first, this may not seem like a very fruitful area ofinquiry. After all, the United States and the countries of conti-nental Europe that Alesina and Glaeser examine are all liberaldemocracies. How, then, could those countries’ political sys-tems explain the difference in the sizes of their welfare states?

The answer is that most European democracies have sig-nificantly different rules for implementing public policiesthan does the United States. In particular, most Europeanstates have systems of proportional representation thatmake it possible for fringe parties, such as the Socialist andCommunist parties, to gain entryto the political system and buildcoalitions with more mainstreamleft-of-center parties. Once inpower, the fringe actors often caninfluence the platform of the broadleft-wing coalition, pushing it toadopt more radical proposals,which lead to greater redistribu-tion of income.

In contrast, the American winner-takes-all system tendsto encourage candidates to move more closely to the posi-tions of the median voter, as the economist Anthony Downsexplained in his seminal 1957 book An Economic Theory ofDemocracy. Such a system makes it difficult for third-partycandidates to win office, or even for more ideologicallyextreme candidates within a major party to gain power.Consider that of the 435 members of the U.S. House ofRepresentatives, 434 belong to one of the two major parties.Bernie Sanders of Vermont, an Independent, is the onlyexception.

But this begs the question: What caused the states of con-tinental Europe to adopt systems of proportional representa-tion? After all, those systems are relatively new, with mostbeing adopted in the 20th century. Alesina and Glaeser offertwo explanations.

First, labor strikes in the early 1900s effectively shut downeconomic life in the smallest states of continental Europe(Belgium, the Netherlands, and Switzerland) as well as inthose states where the population is highly concentrated inone or two cities (Finland and Sweden). As a result of thesecrippling strikes, the labor movement was able to effectivelypush for electoral reform. Second, in many of the larger statesof continental Europe (Austria, Germany, and Italy), systemsof proportional representation were adopted following WorldWar I, when those countries were in economic and politicaldisarray. So although the United States is a much “newer”country than most of the states of continental Europe, itspolitical institutions tend to be significantly older and more

stable. Perhaps most important, they are designed to makeradical change relatively difficult to achieve.

Race and IdeologyAlesina and Glaeser argue that race also can help explain dif-ferences in the American and European welfare states. TheUnited States is a much more diverse society than any of thecountries of continental Europe, and in America povertytends to be highly concentrated among minority groups. “As aresult, it is much easier to convince a white middle-class per-son in the United States to think that the poor are ‘different’(read black) than to convince a white middle-class person,say, in Sweden,” Alesina and Glaeser write. Such “racial divi-sions and racial preferences appear to deter redistribution,”they conclude.

This argument may generally be correct. But one is leftwondering how the passage of Great Society programs, which

greatly expanded America’s welfarestate, fits into this story. Those pro-grams, of course, were passed in themid-1960s, as the Civil Rightsstruggle also was gathering steam.It’s true that widespread backlashagainst those programs, as well aslaws that helped protect civil rights,arguably cost the Democrats sup-port in the South and thus retarded

further expansion of the welfare state. But it’s not clear howMedicaid and the Department of Housing and UrbanDevelopment, both of which benefited minorities dispropor-tionately, would have passed initially if race was the impor-tant factor that Alesina and Glaeser suggest.

Also, the authors may not have paid sufficient attention toideology. This is understandable: Ideology is hard to measure.But it surely was an important factor in explaining whyAmerica’s Founders established the political system they did.And that is true even if one also accepts, as Alesina andGlaeser do, that the Founders had a large economic stake inpassing a constitutional structure that placed relatively tightlimits on government. Ideology also helps us understand whythat political system remained largely unchanged during theGreat Depression. The New Deal significantly expanded therole of the state, to be sure, but America’s fundamental politi-cal structure remained intact, even in a time of extreme crisis.

ConclusionAt the outset of the book, Alesina and Glaeser inform read-ers that their “interest is in the explanation of why the wel-fare state, not in its costs and benefits.” Overall, they havemade an important contribution to this enduring debate.One hopes that they will now turn their formidable analyti-cal powers toward answering that question which they haveleft unaddressed: What have these quite different welfarestates meant for the economic well-being of the UnitedStates and continental Europe? Such a discussion wouldmake for an excellent companion volume. RF


U.S. political institutions make

radical changerelatively difficult.


One of the District’s largest retail-ers, Richmond, Va.-based Circuit City,continued to struggle in a difficultretail environment. In February, itannounced the closing of 19 stores,mainly in the Midwest, in an effort tocut costs. A distribution center inDoswell, Va., will also be closed.

Manufacturing Growth Slows In order to gauge developments in themanufacturing sector, the RichmondFed now releases a composite manu-facturing index. This index morebroadly reflects activity in the sectorby combining what manufacturers tellus about shipments, new orders, andemployment. The composite indexsuggests that growth in manufacturingactivity slowed substantially in thefourth quarter of 2004. The weakerreadings were the result of lower indexvalues for shipments, new orders, andemployment during the quarter.

Reports of higher prices for rawmaterials were more in evidenceamong respondents in October andNovember. Steel, plastic, and naturalgas were among those commoditiesmost frequently mentioned as risingrapidly in price. But raw materialprice hikes eased toward the end of the year, and prices for finishedgoods rose only modestly.

District Job Performance Bests Nation’s We track monthly payroll employ-ment numbers closely because thesedata are among the timeliest measuresof economic performance available atthe state level.

Fifth District payroll employmentin the fourth quarter was 1.9 percenthigher than a year earlier, a somewhatstronger growth rate than the 1.6 per-cent rate of the United States as awhole. Growth was above 2 percent inMaryland and Virginia, the two fastest-growing states in the District. By sec-tor, employment growth continued tobe centered in services.

House Prices SoarHouse prices in the District ofColumbia and in parts of Marylandand Virginia have skyrocketed overthe last year. HUD’s Office ofFederal Housing EnterpriseOversight tracks state-level houseprices on a quarterly basis. Accordingto their statistics, prices in theDistrict of Columbia in the thirdquarter of 2004 were 23 percenthigher than a year earlier.

Increases in Maryland andVirginia were 19 percent and 16 per-cent, respectively. Prices in otherFifth District states rose at a moremodest 5 percent to 8 percent paceduring the period.


Economic growth was relativelystrong in most sectors of the

Fifth District economy in thefourth quarter of 2004. The broadservices sector expanded at a solidpace as ongoing gains in employ-ment and income drove demand forservices higher.

Housing markets were particu-larly strong; new home constructionwas well above the pace of a year ear-lier and home prices rose sharply in anumber of District states. Manu-facturing was a soft spot, however, asgrowth in shipments and new ordersslowed and factory employmentedged lower. Job growth was some-what stronger in other sectors of theeconomy, though, pushing theDistrict’s unemployment rate downto 4.6 percent.

Services Sector Expands but Retail SoftThe Fifth District’s services sectorexpanded at a brisk pace during the fourth quarter. Services firms gener-ally reported solid revenue growththroughout the period. Retailers saidmerchandise sales growth was spottyearly in the quarter, but improved in lateDecember. Sales of automobiles andother big-ticket retail items, though,were soft throughout the quarter.

DISTRICT ECONOMIC OVERVIEWB Y R O B E R T L A C Y

Economic Indicators4th Qtr. 4th Qtr. Percent Change

2004 2003 (Year Ago)

Nonfarm Employment (000)Fifth District 13,254 13,011 1.9U.S. 132,294 130,168 1.6Real Personal Income ($bil)Fifth District 870.5 838.2 3.9U.S. 9,152.4 8,794.2 4.1Building Permits (000)Fifth District 53.4 49.8 7.1U.S. 471.7 451.8 4.4Unemployment Rate (%)Fifth District 4.6% 5.3%U.S. 5.4% 5.9%

“The Fifth Districteconomy continued to

expand at a solid pace as2004 came to a close.”



Unemployment RateFirst Quarter 1992 - Fourth Quarter 2004

House Price Index(1980 Q1 = 100)First Quarter 1994 - Fourth Quarter 2004

Real Personal IncomeChange From Prior YearFirst Quarter 1992 - Fourth Quarter 2004

MDNCSC

VAWVDC

FRB—Richmond Manufacturing Composite IndexFirst Quarter 1994 - Fourth Quarter 2004

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

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

For more information, contact Robert Lacy at 804-697-8703 or e-mail [email protected].

1994 1996 1998 2000 2002 20041994 1996 1998 2000 2002 2004

8%

7%

6%

5%

4%

3%

7%

6%

5%

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1%

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500

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1992 1995 1998 2001 2004 1992 1995 1998 2001 2004

Nonfarm EmploymentChange From Prior YearFirst Quarter 1992 - Fourth Quarter 2004

FRB—Richmond Services Revenues IndexFirst Quarter 1994 - Fourth Quarter 2004

40

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10

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4%

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1994 1996 1998 2000 2002 2004

1992 1995 1998 2001 2004

United StatesFifth District

8%

7%

6%

5%

4%

3%

Nonfarm EmploymentMetropolitan AreasChange From Prior YearFirst Quarter 1992 - Fourth Quarter 2004

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

-1%

-2%

-3%1992 1995 1998 2001 2004

Unemployment RateMetropolitan AreasFirst Quarter 1992 - Fourth Quarter 2004

9%

8%

7%

6%

5%

4%

3%

2%1992 1995 1998 2001 2004

Building PermitsChange From Prior YearFirst Quarter 1992 - Fourth Quarter 2004

30%

20%

10%

0%

-10%

-20%1994 1996 1998 2000 2002 2004

Baltimore Charlotte Washington Baltimore Charlotte Washington Fifth District United States


proper. Boosted by a surge in defense and homeland security spending and an improved outlook at high-techrelated businesses, fourth-quarter payrolls expanded 4.1 percent and the unemployment rate dropped 0.3 per-centage points to 3.0 percent.

MarylandBarometers of Maryland’s economic health were gener-

ally bright at the end of 2004. Businesses in the statecontinued to add jobs in the fourth quarter, marking twostraight years of positive payroll growth. Gains camealmost entirely from service-providing establishments —goods producers in the state trimmed jobs during theperiod.

Adding to the upbeat tone, venture capitalists infused$236 million into Maryland businesses in the fourth quarter, almost tripling the third-quarter inflow and registering the largest gain in exactly three years. Themost exciting news was that 38.5 percent of the fundingwent toward seed stage businesses, leading some analyststo suggest the beginning of a long-awaited pickup ininvestor confidence.

Financial conditions at Maryland households alsobrightened. Keeping with stronger payroll growth, thejobless rate fell 0.3 percentage points to 3.9 percent,remaining well below the national rate. In contrast,another indicator of labor force activity — initial joblessclaims — inched higher in the fourth quarter, followingthree quarters of improvement.

Looking at real estate conditions in Maryland, residen-tial activity remained on target, despite a blip in homesales. Sales of existing homes contracted 0.5 percent inthe fourth quarter, making Maryland the only Districtstate to record a slowdown during the period. Despitesofter sales, home prices continued to increase with the


STATE ECONOMIC CONDITIONSB Y A N D R E A H O L L A N D

District of Columbia

As 2004 drew to a close, business conditions in theDistrict of Columbia continued to show improve-

ment, but conditions of households softened. Businessesin the District of Columbia continued to tack on jobs inthe fourth quarter. Payroll employment expanded 0.1 per-cent, marking five consecutive quarters of job growth.Among sectors, education and health services establish-ments led the gains, adding 4,300 jobs. By comparison,

construction posted the weakest performance, trimming733 jobs. Looking ahead, the refurbishment of the RFK stadium and construction of a new major leaguebaseball stadium are expected to create 900 new jobslater this year.

Other recent economic indicators also pointed to anupturn at businesses. Venture capital inflows into Districtof Columbia firms totaled $38 million in the fourth quarter, the largest quarterly increase in three years.

Moving on, the financial conditions of householdswere mixed. The District of Columbia’s unemploymentrate edged up to 8.8 percent in the fourth quarter — thehighest rate since the third quarter of 1998. On a morepositive note, the number of unemployment benefitsclaimants decreased in the fourth quarter, following aslight uptick the quarter before.

Turning to the District of Columbia’s real estate mar-ket, home prices reached an all-time high in the fourthquarter, standing 23.0 percent higher over the year. Butsharply steeper prices didn’t deter buyers — in excess of18,000 homes were sold during the period, a new record.Underlying strength was apparent in readings on futureconstruction as well. Fourth-quarter building permitauthorizations were 3.6 percent above third-quarter levels.

News from the broadly defined Washington, D.C. MSA was more upbeat than in the District of Columbia

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SOURCE: House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics

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North Carolina’s metro areas saw steady job growth inlate 2004. In the fourth quarter, Charlotte and Raleigh-Durham posted payroll employment gains of 11.9 percentand 3.8 percent, respectively. Likewise, both metros saw adecline in their jobless rates. In real estate, new construc-tion activity in Charlotte and Raleigh-Durham mirroredthat of the state. Both posted a significant drop in newbuilding permit authorizations.

South CarolinaGoing into 2005, economic momentum was more evi-

dent in South Carolina than a year earlier. Businessconditions in the state continued to improve. SouthCarolina added 4,176 jobs in the fourth quarter, reversinga modest third-quarter loss. By category, the leisure andhospitality sector displayed the most strength — payrollsincreased by 15,267. By comparison, the largest loss wasrecorded in the professional and business services sector,where employment fell by 3,833.

Adding to the positive tone on the business front, ven-ture capitalists injected $12.3 million dollars into SouthCarolina firms, the largest quarterly inflow since late

2002. Of this total, more that one-third of the venture funding wenttoward a business still in the start-up stage, possibly suggesting apickup in investor confidence.

The latest data suggested thathouseholds in the state may alsobe experiencing a pickup in confi-dence — the number of job seek-ers increased by nearly 10,000 in

the fourth quarter. Despite strong job gains, the sizableincrease in the labor force pushed the unemploymentrate up 0.2 percentage points to 6.6 percent. Initialclaims for unemployment insurance in the fourth


median-priced home now 18.6 percent more expensivethan a year ago. Tracking sales activity, building permitsalso dwindled in late-2004, but remained 4.8 percentabove a year earlier.

The Baltimore metro area economy continued to out-perform the state as a whole. Payrolls rose by a solid 5.1 percent in the fourth quarter, and the jobless rateplummeted 0.5 percentage points to 4.3 percent. Newconstruction activity in Baltimore outperformed otherareas of the state — building permits jumped 73.5 percentfrom the third quarter. In other news, Baltimore’s com-mercial real estate market continued to warm, albeit slowly. Fourth-quarter office and industrial vacancy ratescame in below levels posted a year ago.

North CarolinaNorth Carolina’s economy advanced steadily in the

fourth quarter of 2004. Businesses in the state continued to expand hiring, causing payroll employmentto expand by 1.3 percent in the fourth quarter — the thirdstraight quarterly increase. By sector, job numbers pickedup most at government and leisure and hospitality estab-lishments. By comparison, job losses were greatest in themanufacturing sector, where the broader economic recov-ery has yet to fully establish itself.

In other business news, the latest numbers on venturecapital investment were very encouraging. Fourth-quarterinflows totaled $114 million — the largest quarterly injection in two years. The majority of the capital wasslotted for expansion-stage and later-stage companies.

Household financial conditions remained steady.Despite the solid gain in payroll employment in late-2004,the unemployment rate remained fixed at 5.0 percent asnearly 10,000 new persons entered North Carolina’s laborforce over the period. On a less positive note, the numberof state residents newly applying for unemployment bene-fits rose by 11.8 percent in the fourth quarter, the secondstraight increase.

Switching gears, North Carolina’shousing market continued to gainstrength in the fourth quarter.According to the latest data, homeprices rose 6.1 percent in the fourthquarter. Residential realtors were kepton their toes — existing home salesstood 25.4 percent higher in thefourth quarter compared to a year ear-lier, marking the strongest annual growth rate districtwide.Indicators of future construction were not as robust. Newbuilding permits edged 3.0 percent lower in the fourth quar-ter, following a similar decline in the third quarter.

“Economic momentumwas more evident in

South Carolina than ayear earlier.”

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quarter rose by 16.2 percent but were attributed mainlyto seasonal factors.

As in other Fifth District states, the median price for aSouth Carolina home continued to move higher last year,rising by 5.8 percent. And the evidence suggests thatdemand pulled prices higher. Fourth-quarter existinghome sales were 15.4 percent higher over the year, mark-ing the second strongest growthrate districtwide. Prospects fornew construction remained ontrack — new building permits filedin the fourth quarter were signifi-cantly higher over the year.

Fourth-quarter activity in SouthCarolina’s metro areas was mixed.Payroll employment expanded at arobust 6.4 percent rate inColumbia, but Charleston experienced a decline in jobnumbers — employment contracted 1.0 percent. Newconstruction slowed in both metropolises in the fourthquarter, but as seen statewide, remained well above year-ago levels.

VirginiaVirginia’s economic prospects continued to brighten

as 2004 drew to a close. The state posted theDistrict’s strongest rate of job growth in the fourth quarter as well as the fifth strongest nationwide for all of 2004.

Fourth-quarter payrolls increased by 0.5 percent, or4,500 jobs, marking the seventh straight quarter ofpositive job growth. Among major industries, govern-ment establishments created the most new jobs, whileeducation and health services businesses cut the mostpositions.

Mirroring national activity, venture capital invest-


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ment into Virginia businesses picked up in the fourthquarter. Capital inflows totaled $73.8 million, nearly dou-ble the amount recorded in the third quarter. By stage ofinvestment, nearly one-fifth of the funds were infusedinto seed and startup businesses.

Household conditions also remained on track in thefourth quarter. The jobless rate dropped 0.2 percentagepoints to 3.3 percent, despite an inflow of 11,300 job seek-ers into the labor market. And although the number offirst-time claimants for unemployment insuranceincreased by 20 percent, the level remained below that ofa year ago.

On the real estate front, the latest readings on homeprices suggest that appreciation has continued to heat up.The state recorded a 10.5 percent jump in the fourth quar-ter alone. As in other states, the increases appear to resultfrom strong demand growth, as illustrated by the 3.4 per-cent increase in fourth-quarter home sales. New construc-tion, however, advanced at a more moderate pace. Thenumber of building permits issued in the fourth quarterwas somewhat below those recorded in the third quarter.

Economic activity in Virginia’s metro areas also con-tinued to look up, with businessesin the Norfolk and Richmondmetro areas boosting payrolls by4.3 percent and 3.0 percent,respectively. Much of Richmond’sjob growth was centered in educa-tion and health services — not asurprise since the city is home toseveral universities and researchhospitals. According to a break-

down of the data, Norfolk’s labor market was boosted byincreased defense and homeland security spending. Inline with strengthening labor markets, the jobless rateposted healthy declines in both areas.

“In Virginia, government establish-

ments created the most new jobs.”


West Virginia

West Virginia businesses trimmed jobs in the finalquarter of 2004 — the only Fifth District state to

do so — suggesting that the economic expansion may nothave been firmly entrenched in 2004.

Compared to states across the nation, West Virginiaranked 41st in terms of job growth in 2004. Fourth-quar-ter payroll numbers slipped 1.7 percent, with reductionssprinkled across establishments on the services side ofthe economy. In contrast, West Virginia goods producersadded jobs during the quarter.

Other business news was more upbeat — venture capi-tal investment into West Virginia businesses totaled $5.3million in the fourth quarter, following flat inflows in thethird quarter. Also positive, nearly 60 percent of theinflows were targeted toward firms in the startup stage.

Moving on, the bounceback at West Virginia house-holds has also been slow to take hold. Mirroring payrollactivity, West Virginia was the only District jurisdictionto record a contraction in the labor force in the fourthquarter. The downsizing of the labor market helped facil-itate the 0.3 percentage point decline in the jobless rate,despite falling payroll numbers. Also less encouraging,initial claims for unemployment insurance rose in thefourth quarter, reversing three consecutive periods ofimprovement.

One bright spot of West Virginia’s economy in recentyears has been real estate, driven in part by historically


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Maryland added 52,300 to the ranks of the employed in2004, according to the Labor Department. No wait —make that 63,800, according to the, er, Labor Department.

What gives? The problem is a simple discrepancybetween two sets of government-generated numbers: theso-called “payroll” and “household” surveys, from whichmonthly U.S. job statistics are derived. The payroll surveyproduced the 52,300 employment growth figure mentionedabove, while the household survey came up with the 63,800number. Sometimes, the differences between the two stud-ies can be even more significant.

In general, economists consider the payroll survey morereliable. Here’s why.

The payroll survey, also called the “EstablishmentSeries,” is based on reports from a sample of about 400,000businesses, covering about a third of nonfarm employment.

By comparison, the household survey uses a sample of60,000 homes.

One other key difference is that the payroll survey asksfirms how many employees they have, while the householdsurvey asks people whether they have jobs. For that reason,some economists say the household survey may be moreeffective in capturing the number of self-employed peoplein the economy as well as in predicting job growth.

Still, “it’s clear the payroll survey is the preferred surveyfor judging changes in business conditions in the nearterm,” says Roy Webb, an economist at the Federal ReserveBank of Richmond. He adds that, shortcomings notwith-standing, the household survey enjoys broad support fromeconomists as another tool in their analysis kit. “As an economic analyst, I always think more data is better,” Webb says. — DOUG CAMPBELL

Behind the Numbers

low mortgage rates and relatively affordable housing.Fourth-quarter home prices expanded at a healthy rate,by 7.6 percent. Some of the price increase likely stemmedfrom playing catch up with surrounding states, as WestVirginia home prices remain the lowest districtwide.Affordable prices have apparently attracted homebuyers,though — sales of existing housing units rose by 4.0 per-cent in the fourth quarter.

Economic activity was a bit more upbeat in theCharleston metro area than in other areas of the state.Payrolls in that area continued to move higher, rising 0.6percent in the fourth quarter. In line with the improve-ment in hiring activity, Charleston’s jobless rate fell 0.1percentage points to 4.1 percent.


DC MD NC SC VA WV

Nonfarm Employment (000) 672.3 2,538.7 3,874.9 1,839.0 3,595.5 733.4

Q/Q Percent Change 0.1 0.5 1.3 0.9 0.5 -1.7

Y/Y Percent Change 1.2 2.1 1.8 1.4 2.2 1.5

Manufacturing Employment (000) 2.5 144.2 576.5 269.8 295.0 63.4

Q/Q Percent Change 0.0 -0.5 -3.9 -0.9 -0.5 0.0

Y/Y Percent Change -2.6 -0.5 -2.2 -1.5 -0.7 -0.9

Professional/Business Services Employment (000) 146.9 370.9 447.5 188.7 581.5 56.5

Q/Q Percent Change 3.0 -3.3 3.3 -7.7 0.3 -3.7


Government Employment (000) 231.9 462.7 664.2 336.0 660.3 142.3

Q/Q Percent Change -0.4 -2.8 6.0 1.7 3.9 -4.9


Civilian Labor Force (000) 307.8 2,956.9 4,187.6 2,082.0 3,853.5 801.0

Q/Q Percent Change 9.2 0.6 0.9 1.8 1.2 -0.8

Y/Y Percent Change 2.3 1.7 -1.6 3.3 1.8 2.7

Unemployment Rate (%) 8.8 3.9 5.0 6.6 3.3 5.0

Q3:04 7.8 4.2 5.0 6.4 3.5 5.3

Q4:03 7.0 4.5 6.3 6.9 3.9 5.7

Personal Income ($bil) 27.0 205.4 236.0 107.5 250.2 44.3

Q/Q Percent Change 1.6 1.6 1.5 1.3 1.7 1.7


Building Permits 347 7,211 20,382 10,677 13,669 1,082

Q/Q Percent Change 15.1 -11.5 -49.2 -5.2 -48.4 -70.3

Y/Y Percent Change 298.9 4.8 4.8 30.0 -2.8 -3.9

House Price Index (1980=100) 496.2 403.4 289.3 270.7 369.3 215.2

Q/Q Percent Change 19.9 9.8 6.1 5.1 10.5 7.6


Sales of Existing Housing Units (000) 18.1 153.4 375.1 176.4 210.1 39.3

Q/Q Percent Change 19.1 -0.5 4.4 4.7 3.4 4.0



State Data, Q4:04

NOTES:Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics, Manufacturing, thousands of jobs, SA; BLS/Haver Analytics, Professional/Business Services, thousands of jobs, SA; BLS/Haver AnalyticsGovernment, thousands of jobs, SA; BLS/Haver Analytics, Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics, Unemployment Rate, percent, SA; BLS/Haver Analytics, Personal Income, billions of chained 2000$, Bureau of EconomicAnalysis/Haver Analytics, Building Permits, number of permits, NSA; U.S. Census Bureau/Haver Analytics, House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics, Sales of Existing Housing Units, thousands of units, SA; NationalAssociation of Realtors®


S u m m e r 2 0 0 5 • R e g i o n F o c u s 51

Washington, DC MSA Baltimore, MD MSA Charlotte, NC MSA

Nonfarm Employment (000) 2,937.2 1,282.3 856.6

Q/Q Percent Change 4.1 5.1 11.9

Y/Y Percent Change 2.7 2.0 2.8

Unemployment Rate (%) 3.0 4.3 5.2

Q3:04 3.3 4.8 5.5

Q4:03 3.3 4.9 6.8

Building Permits 7,866 2,884 4,642

Q/Q Percent Change -57.9 73.5 -61.2

Y/Y Percent Change 2.1 -5.8 3.2

Raleigh, NC MSA Charleston, SC MSA Columbia, SC MSA

Nonfarm Employment (000) 703.3 266.7 307.5

Q/Q Percent Change 3.8 -1.0 6.4



Q3:04 3.3 4.6 4.3

Q4:03 4.2 4.5 4.0

Building Permits 3,099 2,059 1,649

Q/Q Percent Change -45.3 -29.5 -23.6

Y/Y Percent Change -5.8 22.3 44.3

Norfolk, VA MSA Richmond, VA MSA Charleston, WV MSA

Nonfarm Employment (000) 750.4 575.1 134.5

Q/Q Percent Change 4.3 3.0 0.6



Q3:04 4.4 4.2 4.2

Q4:03 4.1 4.0 4.2

Building Permits 2,621 2,127 68

Q/Q Percent Change 44.4 -40.3 -76.8

Y/Y Percent Change -16.8 -1.1 4.6

Metropolitan Area Data, Q4:04

For more information, contact Andrea Holland at 804-697-8273 or e-mail [email protected].

Pg 51 KC.ps - 4/29/2005 12:02 PM

We are a nation built on capitalism. Americans valueprogress and venerate the entrepreneurs whoblaze new trails in the pursuit of profits.

As a nation born of revolution, however, we also distrust anyinstitution that gets too big for its britches. Entrepreneurs fromAndrew Carnegie to Bill Gates became magnets of criticism astheir once-fledgling companies grew into corporate behemoths.

The truth is big business is neither a bully nor a benefactor.Its goal is to make money. In the process, it tends to serve itsown interests as well as those of consumers. However, not allfirms conduct themselves in ways that the public deemssocially acceptable.

America’s love-hate relationship with big business predatesthe appearance of the first Wal-Mart discount store. The late1800s saw the rise of industrial powerhouses like Standard Oiland U.S. Steel. Magnates such as John D. Rockefeller and J.P.Morgan profited as wealth became more concentrated andfears of diminishing market competition grew.

However, they weren’t supposed to be the only ones madebetter off by industrial concentration. This was supposed to begood for society in general. MorganWitzel, in his introduction to an editedvolume titled Big Business and the Muck-Rakers, 1900-1910, explains the mindsetat the time: “Without the need to com-pete and spend money fighting offbusiness rivals, corporations could con-centrate on becoming more efficient,reducing costs, and providing cheapergoods to the public.”

Things didn’t turn out that way,though. Many prices didn’t fall and inefficiencies remained.On top of that, labor unrest increased and scandals over work-er safety and product quality made the headlines of muckrak-ing magazines like McClure’s. Also, some companies, particu-larly railroads, used their economic power to garner favorabletreatment by lawmakers.

Fast-forwarding to the 1980s, corporate raiders like CarlIcahn and Boone Pickens led hostile takeovers of companiesand carved their acquisitions into pieces to sell off at a quickprofit. While businesses across America consumed a lot oftime and money to keep these wolves at bay, some argue thatmany weak operations were eliminated, which executives maynever have shuttered.

Then there was the spate of corporate scandals of the late1990s and early 2000s. Companies like Enron, WorldCom,and Adelphia Communications based their growth on ques-tionable accounting practices and financial arrangementsobscured from public scrutiny. Eventually, their actions were

uncovered, undermining trust in their companies and leadingto criminal investigations of CEOs and CFOs.

At this point, you may be wondering: “I thought he said bigbusiness wasn’t inherently evil? It sure sounds like that’s thecase.”

Well, it isn’t. Once a company reaches a certain size, it canreduce its average total costs over the long run by employingmachinery that is more efficient, dividing processes andassigning them to specialized workers, and earning discountson bulk purchases. Such economies of scale enable companiesto lower their prices for goods and services, which benefits theconsumer.

This alludes to another aspect of becoming big — it isoften the result of consumers rewarding a company for givingthem what they want. If some firms can satisfy their cus-tomers more effectively than their rivals, they will sell more,resulting in increased concentration in an industry.

Microsoft, for instance, now controls an overwhelmingshare of its market. While the company’s current size maydampen its incentive to be innovative, who could really think

that we would be better off withoutits products?

Rather than focus on “bigness,”perhaps we should think about whybusinesses, large or small, go astray. Forexample, one could argue that exces-sive regulation provides an incentivefor companies to seek out shortcutsthat skirt the edge of ethical behavior.Such regulation also may create barri-ers to entry for new companies.

The more important issue may be the complexity of a com-pany rather than its size. “… Innovative financing techniqueshave made it more difficult for outside investors to under-stand a particular firm’s risk profile and the performance of itsvarious lines of business,” noted Fed Governor Susan SchmidtBies in a February 2004 speech. “Traditional accounting stan-dards have not kept pace with the risk-management toolsemployed by sophisticated corporations.” Bies suggested thatimproved corporate transparency would help market partici-pants gauge a company’s strategies and actions.

Ultimately, markets exist to optimize the use of scarceresources and produce what people value most. They are con-cerned with efficiency, not morality. Therefore, consumersmust serve as the moral compass of Corporate America. Theexecutives in charge may be obligated to make money forshareholders, but they have to satisfy consumers in order tomeet that goal. In the ideal marketplace, good behavior will berewarded and bad behavior will be punished. RF


OPINIONEvil Empire?B Y C H A R L E S G E R E N A

“Economies of scale enable

companies to lower their prices

for goods and services, which

benefits the consumer.”


Economic HistoryIn the late 1950s, leaders from academia, business, and government envisioned creat-ing a research community in the pine forestsbordering Raleigh, Durham, and Chapel Hill.That dream became reality, and todayResearch Triangle Park is home to more than100 organizations and 38,000 employees.

Interview A conversation with Robert Whaples, an eco-nomic historian at Wake Forest Universityand director of EH.Net.

Book ReviewFreakonomics: A Rogue EconomistExplores the Hidden Side of Everythingby Steven Levitt and Stephen J. Dubner.

Corporate GovernanceIt’s been more than three years since accounting scandals atEnron, WorldCom, and other companies led to the passage ofthe Sarbanes-Oxley Act. That legislation was designed to shedlight on corporate misconduct by enhancing disclosure require-ments and changing audit rules. How have companies in theFifth District responded to these new regulations?

Base ClosuresIn May, the Department of Defense will announce its recom-mendations for additional closures of military installations.We’ll look at what’s happened to the community surroundingFort Pickett, Va., in rural Nottoway County, since that base wasclosed in the mid-1990s.

Job Market for Recent GraduatesThis may be the best job market for new graduates since thelate 1990s — though it’s not quite rising to the frenzied levels ofthe dot-com boom. Find out what college recruiting offices andstudents have to say in this survey of recent grads’ experiencesin getting their careers started.

Economics of Indian ReservationsIndian reservations are among the poorest places in the UnitedStates, with per-capita incomes well below the national average. Why? We’ll travel to one of the Fifth District’s largestreservations in search of an answer.

www.richmondfed.org

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Quarterly contains original

research from the Bank’s economists

and visiting scholars. To be added to

the EQ mailing list or to view the

issues online, please visit

http://www.richmondfed.org

Winter 2005: Vol. 91, No. 1

K Alexander L. Wolman and Fan Ding, Inflation and ChangingExpenditure Shares

K Yongsung Chang and Sun-Bin Kim, On the Aggregate Labor SupplyK John R. Walter, Depression Era Bank Failures: The Great Contagion or the

Great Shakeout?K John A. Weinberg, Banking Markets in a Decade of Mergers:

A Preliminary Examination of Five North Carolina Markets

Fall 2004: Vol. 90, No. 4

K Thomas M. Humphrey, Ricardo versus Wicksell on Job Losses andTechnological Change

K Andreas Hornstein, (Un)Balanced Growth

K Edward Simpson Prescott, Auditing and Bank Capital Regulation

K Matthew Harris, Raymond Owens, and Pierre-Daniel G. Sarte,Using Manufacturing Surveys to Assess Economic Conditions

Summer 2004: Vol. 90, No. 3

K J. Alfred Broaddus, Jr., and Marvin Goodfriend, Sustaining Price Stability

K Marvin Goodfriend, Monetary Policy in the New Neoclassical Synthesis: A Primer

K Robert L. Hetzel, How Do Central Banks Control Inflation?K Yash P. Mehra, Predicting the Recent Behavior of Inflation Using Output

Gap-Based Phillips Curves

Spring 2004: Vol. 90, No. 2

K Kartik Athreya, Shame As It Ever Was: Stigma and Personal BankruptcyK Margarida Duarte, Monetary Policy and the Adjustment to Country-Specific

ShocksK Huberto M. Ennis, Some Recent Trends in Commercial BankingK Roy H. Webb, Which Price Index Should a Central Bank Employ?

F R B R I C H M O N D

Economic Quarterly


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