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bank of dallas ROLLING RsECESSIONS EGIONAL ECONOMIES ARE growing across the nation, lead- ing some to observe that this shared national expansion differs considerably from the traditional seesaw of regional downturns and upswings. However, this perception about the past is based on the relatively recent experience of the R 1980s and early 1990s, in which some regions contracted while others expanded. Before then, regional economies tended to move together. What contributed to this out-of-sync behavior? Does the situation differ today? A continuation of this pattern of regional disparities could have significant implications for the national . Just as the nation is composed of regions, the national business cycle can be thought of as the sum of regional business cycles. If parts of the nation expand while others contract, the nation as a whole may have INSIDE less severe and less volatile business cycles. The current U.S. expansion, along with the expansion of the 1980s, has been ex- Is the Fed Slave to a ceptionally long, far exceeding the four-year average for post–World Defunct Economist? War II expansions. One contributor to this phenomenon may be diverging regional business cycles. Corporate Financing Many factors can cause regional business cycles to differ. For ex- And Governance: ample, national shocks may affect regions differently, due to differ- An International Perspective ing tax and regulatory environments or combinations of labor and capital. Regional cycles are also influ- Chart 1 economic activity as gross domestic enced by shocks specific to the region, Cyclical Components of Real product or the unemployment rate. At such as droughts or regional regulatory Personal Income of 12 Federal the state or Federal Reserve district changes. Reserve Districts, 1953–91 level, a narrower range of indicators is One particular explanation for di- Percent available, such as personal income and verging regional cycles gained promi- 10 employment. nence in the 1980s—“rolling recessions.” 8 The cyclical components of personal

Analysts coined this term to describe a 6 income in the 12 Federal Reserve dis- phenomenon in which some industries 4 tricts are shown in Chart 1. The picture experienced downturns in reaction to 2 reveals that the cyclical components of shocks, or changes in the national econ- personal income tend to move together, 0 omy, while others continued to do well. increasing and decreasing at about the –2 These rolling recessions may have led same time, although not perfectly and –4 to divergent regional cycles as regions not at all times. To the extent the cycles –6 with varying output mixes reacted dif- ’53 ’57 ’61 ’65 ’69 ’73 ’77 ’81 ’85 ’89 are similar, this suggests that regional ferently to each industry downturn. San Francisco St. Louis Cleveland cycles are responses to changes in the While industry downturns may have Dallas Chicago Philadelphia national economy, rather than region- Kansas City Atlanta New York influenced the regional economic differ- Minneapolis Richmond Boston specific changes. As can be seen in ences of the 1980s and early 1990s, Chart 1, the degree of correlation of other factors were also at work, such as economic activity among the 12 Federal differences in taxes, local construction Reserve districts was strongest for the cycles and labor costs. These factors a decade or more. For example, over a cycle associated with the run-up to the may become relatively more important long period, employment numbers will oil price of 1974. in future regional differences, as in- trend upward with a growing popula- During the 1980s, however, there creasingly similar regional output mixes tion. Elimination of both the short-term were signs that the districts’ cycles were should lead to more similar responses ups and downs and the long-term becoming less synchronized, to a de- to industry shocks. trends leaves the cyclical components, gree not seen in earlier postwar which show where the economy is decades. While there were a few years relative to where it would be if it grew before the 1980s in which some regions Business Cycles at a nice, steady pace over the years. diverged, the disparities were not as There are a number of ways to pronounced or as frequent. Chart 2 There are two basic ways of looking divide the nation for the purpose of shows the same pattern for employ- at the business cycle. The one underly- studying regional cycles, such as at the ment. It is difficult to say how close the ing most media discussion focuses on state or census-region level. One inter- regional cycles are today. While regions absolute increases and decreases in eco- esting approach is to look at regions across the country are growing in terms nomic activity. For example, an increase that form or encompass clusters of eco- in many indicators, such as employment nomic activity, which was the basis for and gross domestic product, over many how the country was divided when the months is considered an expansion. Federal Reserve districts were deline- Chart 2 Cyclical Components of Conversely, a decline in these indicators ated in 1913. One might expect to find, Nonfarm Employment over many months is regarded as a con- within each area of concentrated eco- Of 12 Federal Reserve traction. nomic activity, a common business Districts, 1953–93

An alternative definition of the busi- cycle that could differ from that of Percent ness cycle, which this article uses, is another location. Although the econ- 4 grounded not in terms of absolute omy has evolved since 1913, this divi- 3 increases and decreases in economic sion seems reasonable for an analysis of 2 activity but in terms of fluctuations regional business cycles. around a trend. When economists look 1 at economic indicators, they first ex- 0 clude the seasonal patterns, such as the Do Regional Cycles Just Reflect –1 increase in holiday retail sales, to get a –2 more accurate picture of how the econ- National Industry Cycles? –3 omy is doing relative to other times of –4 ’53 ’57 ’61 ’65 ’69 ’73 ’77 ’81 ’85 ’89 ’93 the year. When looking at business As already noted, one can think of San Francisco St. Louis Cleveland cycles, economists go a step further, the business cycle in terms of fluctua- Dallas Chicago Philadelphia eliminating not only these short-term tions in economic activity around the Kansas City Atlanta New York Minneapolis Richmond Boston changes but also the trends—changes trend. At the national level, economists that occur over a long horizon, such as typically focus on such indicators of

Page 2 Southwest Economy September/October 1997 of absolute measures, they may still dif- Chart 3 before the 1980s, such as the oil price fer in terms of movement around their Cyclical Components of changes and defense cuts of the 1970s, trends. Unfortunately, the econometric Real Personal Income were not accompanied by widely vary- techniques used to obtain cyclical com- Of the Dallas and Boston ing regional responses, in spite of a ponents do not allow reliable estimates Districts, 1980–91 greater degree of regional industry con- for more recent years. Percent centration. The cause of this increased The divergence in regional cycles in 3 responsiveness to industry shocks in the 4 the 1980s may have been caused by a 2 Boston 1980s is still unknown. series of changes in the national econ- 1 omy that had varying effects on regions 0 due to their differing regional output –1 Other Regional Influences Dallas mixes. This is consistent with the notion –2 of rolling recessions—different indus- –3 The series of national shocks to tries experiencing downturns at differ- –4 the manufacturing, energy and defense ent times—that permeated U.S. policy industries is clearly reflected in move- –5 discussions in the 1980s. For example, a ’80 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ments in Federal Reserve districts’ per- manufacturing downturn hit the Mid- sonal income and employment. Regions west in the early 1980s. Then the oil responded differently to these shocks price drop of 1986 hurt the oil patch, because they had differing degrees of and defense cuts stung California and defense spending caused the defense dependence on these industries. How- New England in the early 1990s. In industry to decline. This national shock ever, other region-specific factors also addition, these downturns caused some was clearly a source of weakness for influence regional cycles. migration of workers, which in turn New England and some other areas of For example, a change in federal tax helped fuel other regions’ expansions, the country, such as California. Dallas laws affects states differently, depending such as those of Texas and California in Fed economist Lori Taylor studied em- on state tax structure. States may choose the early 1980s. ployment sensitivity to defense spend- from a variety of levies to raise revenue, Studies of rolling recessions’ effect ing by state, based on each state’s such as sales, income, property and busi- on regional economies in the 1980s industrial mix and each industry’s sensi- ness taxes. Since some of these taxes centered on absolute increases or de- tivity to defense spending.1 She found are not deductible against federal in- creases in regional indicators such as that Connecticut was the most defense- come taxes, sensitivity to changes in employment, gross state product or sensitive state because of its high con- federal income taxes will depend on personal income. However, looking at centration of transportation equipment the state tax structure. In addition, these fluctuations around the trend, the same manufacturing, particularly shipbuilding. differences in taxes, or in government patterns appear. In 1985, personal in- For example, as Chart 4 shows, trans- services and quality of life, can lead come in the Midwestern districts de- portation equipment manufacturing fell to various combinations of labor and creased toward their trends with the much further than the national average capital across regions. Differing capital– decline of the manufacturing sector, in states with a high concentration of labor mixes in turn contribute to vary- while personal income in the Dallas defense-related transportation manufac- ing regional responses to national and Kansas City districts continued to turing, such as Connecticut and Cali- shocks, such as changes in minimum increase. This decline in certain national fornia. In addition to Connecticut, other wage laws or capital gains taxation.5 manufacturing industries affected the New England states had above-average Midwest to a greater extent because sensitivities, due in part to high concen- of the region’s larger concentration of trations of electronics manufacturing. Chart 4 these industries. If these rolling recessions were to Change in Transportation The following year, the oil industry recur, the regional responses might be Equipment Manufacturing plummeted with the oil price shock less disparate since there is evidence Employment, 1988–93 of 1986. Oil price changes, although that over the decades regions have be- Percent national shocks, affect the cycles of come more similar in terms of industry 0 2 energy-producing and energy-consuming mix. For example, Dallas Fed econ- –5 regions differently. In 1986, when oil omists Steve Brown and Mine Yücel –10 prices dropped by half, Texas’ personal found that because state economies are –15 income plunged below trend. But while becoming more similar in their compo- the oil price drop had a large negative sition, the variation across states in the –20 impact on the Texas economy, it response to changing oil prices is nar- –25 3 spurred growth in other parts of the rowing. However, industry mix does –30 country, such as New England, as en- not seem to be the only determinant of –35 ergy costs fell (Chart 3 ). regional response to an industry down- California Connecticut A few years later, cuts in national turn. The industry shocks that occurred

Federal Reserve Bank of Dallas Page 3 Implications for the Economic and Monetary Union Conclusion Business cycles at the Federal Reserve district level may shed light on what Europeans The concept of the rolling can expect under the Economic and Monetary Union (EMU), scheduled to go into effect January 1, 1999.1 In discussions of EMU’s likely implications for Europe, the United States emerged in the 1980s in response to is often cited as an example of an enduring monetary union, while the U.S. central bank, shocks in the economy that affected the Federal Reserve, is cited as a model of how a central bank would function in a mone- some industries more than others. By tary union. Thus, at least in principle, the business-cycle experience of the U.S. regions extension, the downturns in these in- holds useful lessons for what Europe can expect under EMU. Dallas Fed economists Mark Wynne and Jahyeong Koo found a greater similarity among dustries, in combination with other eco- Federal Reserve district business cycles than among those of prospective EMU members. nomic influences, affected some regions Insofar as the United States can be a model of what might occur in Europe with a credible more than others, causing some areas monetary union, these patterns suggest the possibility of greater synchronization of busi- of the country to experience slowing of ness cycles across EMU countries than has been the case in the past. However, important differences remain between the Federal Reserve System and EMU, such as the degree to their economies while others saw their which each region or EMU country can influence economic policy. Policy differences, such economies expand. Whether the diver- as those that affect the cost of doing business, influence economic activity within the United gence of the 1980s represents just a States. The policy differences between the EMU countries are likely to be even more temporary phenomenon unlikely to be important than those of regions with much less autonomy. repeated or a fundamental change in the 1 Mark A. Wynne and Jahyeong Koo, “Business Cycles Under Monetary Union: EU and U.S. Business characteristics of the national economy Cycles Compared,” Federal Reserve Bank of Dallas Working Paper no. 7, 1997. cannot be determined without further study and a longer period of observa- tion. Therefore, it is too soon to tell if the The construction sector, although in- while the U.S. economy and oil prices regional business cycles are currently in fluenced by national factors such as had the largest effect, the construction sync or not. and tax law changes, also sector also had a significant impact. — Sheila Dolmas responds to local characteristics. For Another example of region-specific Mark A. Wynne instance, changes in a region’s industry influences can be found in New Eng- Jahyeong Koo mix or demographic characteristics may land’s late-1980s downturn. Although trigger a change in construction activity. defense cuts and nationally declining This response to local characteristics manufacturing industries certainly con- may lead construction activity to diverge tributed to the downturn, a loss of s from economic activity that is more de- market share to competitors in other Notes pendent on national demand. For ex- regions was also to blame. Edward ample, in the 1980s, both New England Moskovitch, in a Boston Fed article, re- 1 Lori Taylor in Defense Spending & , James A. and Texas experienced construction ported that a wide range of durable Payne and Anandi P. Sahu, editors (Oxford: Westview Press, 1993), pp. 203 – 20. booms as other parts of their economies goods industries lost market share in 2 Sukkoo Kim, “Expansion of Markets and the Geographic Distribution 8 slowed. Although oil prices fell in 1982 the mid-1980s. Moskovitch cited the of Economic Activities: The Trends in U.S. Regional Manufacturing and the Texas economy slowed, Texas high cost of doing business in the re- Structure, 1860–1987,” Quarterly Journal of Economics 110 construction activity surged throughout gion, compared with other regions, as (November 1995): pp. 881– 908. 3 the mid-1980s. This boom was due in the reason for the decline across so Stephen P. A. Brown and Mine K. Yücel, “Energy Prices and State Economic Performance,” Federal Reserve Bank of Dallas Economic part to Texas banking institutions’ in- many New England industries. Thus, Review, Second Quarter, 1995, pp. 13–23. creased interest in real estate invest- New England’s downturn was fed by 4 There are many opinions about why the 1980s were different. Some ments following losses in energy-related local characteristics as well as national speculate that the Federal Reserve adopted a more forward-looking, lending and Texas thrifts’ ability to fund influences. low policy in the early 1980s. See Ken Emery and Nathan commercial construction projects fol- However, regional factors that greatly Balke, “Inflation and Monetary Restraint: Too Little, Too Late? ” Fed- eral Reserve Bank of Dallas Southwest Economy, Issue 1, 1995, lowing deregulation. Similarly, in the influenced regional economies in the pp. 3–5, for a description of how monetary policy may have changed mid-1980s, New England construction past may not be as important in the course. Such a policy change could potentially influence regional thrived, largely because of strong de- future. Some of these regional charac- business cycles as well. mand from locally oriented industries, teristics may be changing, possibly be- 5 See Lori Taylor and Mine Yücel, “The Policy Sensitivity of Industries masking employment declines in the coming more alike across regions, as and Regions,” Federal Reserve Bank of Dallas Working Paper no. 12, 1996. region’s export-related manufacturing lower transportation costs, better com- 6 For more detail, see Lynne E. Browne, “Why New England Went 6 sector. munications options, and access to the Way of Texas Rather than California,” New England Economic This out-of-sync behavior within the national and international capital mar- Review, January/February 1992, pp. 23 – 41. Texas and New England economies led kets allow firms to locate in places not 7 D’Ann Petersen, Keith Phillips and Mine Yücel, “The Texas Con- Dallas Fed economists to study the in- previously considered. On the other struction Sector: The Tail that Wagged the Dog,” Federal Reserve Bank of Dallas Economic Review, Second Quarter, 1994, pp. 23–33. fluences of the construction sector, oil hand, this may just mean that other 8 Edward Moskovitch, “The Downturn in the New England Economy: prices and the national business cycle characteristics, such as local taxes or What Lies Behind It?” New England Economic Review, July/August on the Texas business cycle of the late quality of life, will become more impor- 1990, pp. 53 – 65. 1970s and 1980s.7 They found that tant influences on business formation.

Page 4 Southwest Economy September/October 1997 IS THE FED SLAVE TO A DEFUNCT ECONOMIST?

OHN MAYNARD KEYNES once to fall whenever GDP growth has much Chart 2 stated that policymakers are exceeded 2 percent. Indeed, the unem- The Phillips Curve

“usually the slaves of some ployment rate has declined in fully nine Fourth-quarter-over-fourth-quarter defunct economist.” Well, accord- of ten years in which growth has ex- GDP price-index growth ing to a wide range of commen- ceeded 2 percent (the exception being 14 tators, recently it’s been Keynes 1992). In two of three years in which J 12 himself who has held policymakers en- growth has fallen short of 2 percent, the 10 thralled.1 These commentators complain unemployment rate has risen. In the that the Fed has tried to “fine-tune” real exceptional year (1995), GDP growth 8 activity—and that, in doing so, the Fed fell below 2 percent by only 1 one- 6 ’69 ’70 ’68 has imposed an artificial speed limit on hundredth of a percentage point. 4 ’67 ’66 the economy and kept the unemploy- The implication is that GDP growth 2 ’65 ’64 ’62 ’63 ment rate unnecessarily high. More at recent rates must eventually drive ’61 0 specifically, Federal Reserve officials are unemployment to zero, unless produc- 3 4 5 6 7 8 9 10 11 accused of having relied too heavily on tivity or the labor force begins to in- Unemployment rate (fourth quarter of prior year) an analytical tool called the Phillips crease at a substantially faster clip than SOURCES: U.S. Department of Labor; U.S. Department curve when deciding whether to raise we have seen so far during this ex- of Commerce; author’s calculations. the federal funds rate. pansion.2 Something is going to have to This article provides some historical give, and that something is likely to be perspective on the critics’ complaints the growth rate of real GDP. and evaluates the merits of their argu- This conclusion leaves open the pos- ments. I argue that Fed policymakers sibility that noninflationary growth of The Phillips Curve would deserve censure if they behaved 2.5 percent or more is feasible over the as the critics claim. However, the critics’ next year or two. It’s on the issue of The downward sloping line shown accusations are largely without merit, whether strong growth can be sustained in Chart 2, fitted to U.S. unemployment and their own policy prescriptions are for another few years that reasonable and inflation data from the 1960s, is flawed. people may disagree, depending on called a Phillips curve. The Phillips their beliefs about the nature of the curve is named after New Zealand-born short-term output–inflation trade-off. economist Alban W. Phillips, who used Current Rates of Output Growth British data to demonstrate that wage inflation tends to be high when the Are Not Sustainable unemployment rate is low. Phillips’ rationalization of this relationship was Chart 1 Over the past three years (1994:1– Rapid Output Is Not simple: the price of a good increases 97:1), real GDP has grown at a 2.9 Sustainable when the good is in high demand. Low unemployment rates are a symptom of percent average annual rate. Over the Year-over-year change in unemployment rate past four quarters (1996:1–97:1), it has high demand for labor, so low un- 2 grown at a whopping 4 percent annual employment rates are associated with ’91 rate. The idea that growth at these rates 1 ’92 rapid increases in the price of labor. can continue indefinitely is appealing ’90 Economists often plot Phillips curves ’86 ’89 0 but unrealistic. Chart 1 shows the rela- ’85 using product price inflation in place of ’95 ’96 tionship between real GDP growth and ’88 wage inflation, because the two types –1 ’93 the change in the unemployment rate ’87 ’94 of inflation tend to move together. since the mid-1980s. For example, the –2 From 1958, when Phillips originally point plotted in the extreme lower ’84 published his research, through the end right-hand corner shows that real GDP –3 of the 1960s, many economists believed –1 0 1 2 3 4 5 6 7 8 rose by 7 percent in 1984, while the un- Year-over-year percent change in real GDP that policymakers could choose any employment rate fell by 2 percentage point along the Phillips curve and hold SOURCES: U.S. Department of Labor; U.S. Department points. More generally, the chart shows of Commerce; author’s calculations. the economy there indefinitely. How- that the unemployment rate has tended ever, the 1970s forced people to rethink

Federal Reserve Bank of Dallas Page 5 the Phillips curve. This reevaluation had Chart 3 machinery and human effort. Supply- two components, which I will discuss Higher Inflation side shocks are also sometimes called in turn. Expectations Shift the productivity shocks. Aside from oil-price Phillips Curve Upward increases, the supply shocks that have Fourth-quarter-over-fourth-quarter received the most attention from macro- Lesson 1: Changes in Inflation GDP price-index growth economists are probably crop failures 14 because of drought or flooding. Expectations Shift the Phillips Curve 12 Just how important are supply shocks? ’74 10 ’80 1974–83 That’s the $64,000 question. Keynesians ’79 ’78 ’81 First, events of the 1970s increased 8 tend to view such shocks as infrequent ’75 appreciation for the importance of infla- ’73 and easily accounted for. It’s this belief ’77 ’76 3 6 ’69 ’70 tion expectations. Milton Friedman and ’71 that drives their policy prescriptions. ’68 ’82 ’83 4 ’72 Edmund Phelps led the charge, arguing ’67 1961–70 For if supply shocks don’t shift the ’66 2 ’65 ’64 that monetary policy is like a drug for ’62 NAIRU around too much, so that its ’63 ’61 which the economy can build up a 0 value can be pinned down, then the tolerance: larger and larger doses are 3 4 5 6 7 8 9 10 11 appropriate policy is obvious: get the required to achieve a given effect. Ini- Unemployment rate (fourth quarter of prior year) unemployment rate to the NAIRU and SOURCES: U.S. Department of Labor; U.S. Department tially, an acceleration in money growth of Commerce; author’s calculations. keep it there. As a practical matter, the puts more real purchasing power in Keynesian prescription is for an unem- people’s pockets. Increased sales mean ployment rate of about 6 percent and more jobs, and unemployment falls. GDP growth of about 2 percent. Consequently, the economy follows a Unfortunately for the Keynesians, path that looks a lot like the Phillips ating inflation rate of unemployment, or more and more analysts are coming curve of the 1960s. However, as the NAIRU. A typical NAIRU estimate is 6 around to the view that supply-side rapid money growth continues, the percent. At unemployment rates below shocks are so pervasive as to seriously economy begins to adapt to it. Eventu- the NAIRU, there is a tendency for in- limit the usefulness of the NAIRU as a ally, wages and prices catch up to the flation expectations to rise. (Such was policy guide. Even after accounting for money supply, and the stimulus to out- the experience of the early 1970s.) At food and energy shocks, NAIRU esti- put and employment fades away. Only unemployment rates above the NAIRU, mates vary substantially from year to higher inflation remains. In Chart 3 (an there is a tendency for inflation expec- year. Moreover, in any given year, the updated version of Chart 2) we see a tations to fall.4 exact value of the NAIRU is not known move to the right as we follow the Unfortunately, you can’t look up the with any confidence. Recent estimates economy from 1970 to 1971 and 1972. value of the NAIRU in an encyclopedia, suggest that the NAIRU is probably At first, Nixon’s wage and price controls and it’s not published in the Wall Street around 6 percent but could easily be as kept inflation down to 4 percent, but in Journal. The NAIRU has to be esti- low as 4.5 percent or as high as 7.5 per- 1973 inflation broke loose and a new mated. A big part of the debate be- cent (Staiger, Stock and Watson 1997). round of stimulus began. By 1974 in- tween those who believe that the Increasingly, analysts regard the NAIRU flation was above 10 percent. Over Phillips curve remains a useful guide estimate du jour as a yellow caution the next 10 years—from 1974 through to policy and those who do not has to sign rather than a red stoplight. 1983—the economy stayed on a new, do with how good a handle we have higher Phillips curve, representing a on the NAIRU at any given moment.5 less favorable short-run trade-off be- That brings us to the second important Has the Fed Been a Slave to the tween unemployment and inflation. lesson that economists learned during The reason for the shift in the the 1970s. Keynesian View of the Phillips Curve? Phillips curve was an increase in infla- tion expectations. In the 1960s, people If, as its critics assert, the Fed has thought that inflation would eventually Lesson 2: The NAIRU Varies been trying to hold the unemployment stabilize at an annual rate of about rate above some preconceived NAIRU, 2 percent. From the mid-1970s to the Over Time—Not Always Predictably then it has bungled the job. As shown mid-1980s, they acted as if inflation in Chart 4, the unemployment rate has would eventually stabilize at an 8 or 9 The sharp oil price increases of the fallen, more or less steadily, from a high percent annual rate. The increase in 1970s made it obvious to everyone that of 7.7 percent in June 1992 to a low of inflation expectations stemmed from supply-side shocks can temporarily 4.8 percent in July 1997. The unem- policymakers’ attempts to keep the un- change the NAIRU and have an im- ployment rate was last above 6 percent employment rate artificially low. portant impact on inflation. A supply three years ago (in July 1994) despite The lowest unemployment rate that shock is any disturbance that alters the fact that, for most of this period, is consistent, over the long term, with the amount of output that can be pro- 6 percent was the generally accepted stable inflation is called the nonacceler- duced from given quantities of land, estimate of the NAIRU. Clearly, the Fed

Page 6 Southwest Economy September/October 1997 Chart 4 cations devices; and increased competi- Chart 6 The Fed Has Not Been a tion because of deregulation and freer Nominal Spending on a Slave to the Phillips Curve global trade. Second, a more uncertain 5 Percent Growth Path

Unemployment rate and more flexible labor market may Index, 1990:4 = 100

8 mean that the unemployment rate has 140 6% Nominal GDP 7.5 become less useful as a measure of 135 slack in the economy.6 Finally, the Fed- 7 130 5% eral Reserve has conducted policy in a 6.5 125 way that has convinced people that it is 4% 6 120 serious about preventing any significant 5.5 resurgence of inflation. 115 5 How has Fed policy accomplished 110 4.5 this task? Fed Chairman Alan Greenspan 105 4 100 1992 1993 1994 1995 1996 1997 may have revealed the answer recently ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 in a speech defending March’s quarter- SOURCE: U.S. Department of Labor. SOURCE: U.S. Department of Commerce. point hike in the federal funds rate. Greenspan said that “persisting—indeed increasing—strength in nominal de- has not been slamming on the brakes. mand for goods and services suggested ing growth is the sum of real growth At most, the Fed has been occasionally to us that monetary policy might not be and inflation, a policy of steady spend- tapping the brakes to slow the unem- positioned appropriately to avoid a ing growth does not preclude strong ployment rate’s descent. buildup in inflation pressures” (CitiCorp real growth, provided strong real growth It’s revealing to look at the unem- 1997). Note that Greenspan’s statement is accompanied by low inflation. Turn- ployment rate in combination with the focuses on the strength of the nominal ing this statement around, there is little inflation rate, rather than in isolation. demand for goods and services, not the danger that inflation will substantially As Chart 5 clearly shows, the short-run real demand. accelerate under a policy of steady Phillips curve shifted down a notch As shown in Chart 6, Federal Reserve spending growth, for inflation can rise during the mid-1980s in response to the policies have kept the level of nominal only to the extent that the economy’s persistently tough anti-inflation stance spending on a fairly steady 5 percent capacity for real growth falls.7 of the Volker Fed. Then, over the 10- growth track over the past six years. Survey results indicate that Federal year period from 1985 through 1994, Modest, steady spending growth is an Reserve policies during the 1990s have unemployment and inflation varied attractive strategy to pursue in the face resulted in a gradual reduction in long- pretty much as though people believed of uncertainty about the output–infla- term inflation expectations. This reduc- that inflation would eventually stabilize tion trade-off. It is a strategy especially tion in expectations has undoubtedly at around 4 percent. Since 1993, despite popular among economists trained in contributed to the benign behavior of a falling unemployment rate, inflation the monetarist tradition. actual inflation in recent years. has held steady. (Look at the points What’s so great about a policy of marked as stars.) It’s beginning to look steady spending growth? Since spend- as though the Phillips curve has shifted Why Not Target Inflation Directly? yet again and that we’re back in the 1960s, with expected inflation down Chart 5 Many of the analysts who have been Is the Phillips Curve around 2 percent. The challenge for Shifting Yet Again? critical of the Fed seem to feel that policymakers is to ensure that we don’t the hallmark of a successful monetary Fourth-quarter-over-fourth-quarter replay the entire 1960s inflation experi- GDP price-index growth policy is not stable output growth (the ence. 14 Keynesian view) and not low and stable spending growth (the monetarist view) 12 but a stable inflation rate.8 These com- Why Has Inflation Been So Tame? 10 1974–83 mentators apparently believe that the 8 Fed should allow output and employ-

Three factors have contributed to the 6 ment to fluctuate arbitrarily, as long as economy’s strong inflation performance 4 inflation remains constant. in recent years. First, we’ve benefited ’95 One problem with this approach is 2 ’96 ’94 ’93 1985–94 from a series of favorable supply shocks. 1961–70 that inflation bounces around so much These shocks have included innova- 0 that a change in trend is often not 3 4 5 6 7 8 9 10 11 tions in health-care management that Unemployment rate (fourth quarter of prior year) apparent for six months to a year after have held down medical cost inflation; SOURCES: U.S. Department of Labor; U.S. Department it has begun. the spread of cheaper, increasingly of Commerce; author’s calculations. Another problem is that the lags be- powerful computers and telecommuni- tween the Fed’s policy actions and their

Federal Reserve Bank of Dallas Page 7 federal reserve w effects on inflation are considerable— thwe most estimates put them at a year or Notes u s o more. When you add the time it takes tt 1 See, for example, Galbraith (1997) and Yardeni (1997a,b). ss for policy to change inflation to the time 2 it takes to recognize that a change in For an elaboration of this argument, see Krugman (1996). e 3 The analysis that follows is developed more fully in Koenig and y c policy is needed, trying to target the in- Wynne (1994). m 4 ono flation rate is a little like trying to drive Just how quickly inflation expectations adjust and what information down a highway at 60 miles per hour in they respond to remain the subject of debate. In empirical work, most heavy fog, and—just to make things in- economists assume that expected inflation is just a weighted average bank of dallas teresting—there’s a five-second delay of past actual inflation rates. Historically, this approximation does well, but in macroeconometrics, as in personal investing, “past per- between when you apply the brakes formance is no guarantee of future results.” The success of the Robert D. McTeer, Jr. and when the brakes are activated. President and Chief Executive Officer standard approach may simply reflect the fact that to date we have It’s easy to call for inflation-rate tar- seen no policy regime changes important enough to have had a Helen E. Holcomb major impact on Fed credibility. First Vice President and Chief Operating Officer geting in a period when constant infla- 5 tion is consistent with a booming For a defense of the Phillips curve as a policy guide, see Meyer Harvey Rosenblum (1997a,b). Senior Vice President and Director of Research economy. One has to wonder whether 6 For an elaboration, see Duca (1997) and Meyer (1997a). W. Michael Cox advocates of inflation-rate targeting will 7 Thus, a policy of stabilizing nominal spending is a compromise Vice President and Economic Advisor be equally vocal the next time we’re hit between an output-stabilization policy and a price-level or inflation- Senior Economists and stabilization policy. See Koenig (1995). Assistant Vice Presidents with a major drought or a run-up in the 8 Analysts expressing such views include Yardeni (1997a,b) and Stephen P. A. Brown, John Duca, price of oil, when holding inflation con- Kudlow (1997). Robert W. Gilmer, Evan F. Koenig stant might require a recession. Director, Center for Latin American Economics, and Assistant Vice President William C. Gruben References Senior Economist and Research Officer The Fed and Its Critics Mine K. Yücel CitiCorp (1997), “Fed: Reaffirming the Move to a Tighter Stance,” Eco- Economists In summary, some commentators have Robert Formaini Jason L. Saving nomic Week 25 (May 19): 1. David M. Gould Fiona D. Sigalla accused the Federal Reserve of pursu- Joseph H. Haslag Lori L. Taylor Duca, John V. (1997), “A Tale of Three Supply Shocks, National Infla- Keith R. Phillips Lucinda Vargas ing a Keynesian strategy. They claim tion and the Region’s Economy,” Federal Reserve Bank of Dallas South- Stephen D. Prowse Mark A. Wynne that, in a mistaken effort to fine-tune west Economy, Issue 2, 1– 4. Marci Rossell Carlos E. Zarazaga real economic activity, the Fed has sti- Research Associates Galbraith, James K. (1997), “Time to Ditch the NAIRU,” Journal of Professors Nathan S. Balke, fled output and employment gains that Economic Perspectives 11 (Winter): 93–108. Thomas B. Fomby, have their origins on the supply side. Gregory W. Huffman, Koenig, Evan F., and Mark A. Wynne (1994), “Is There an Output– Southern Methodist University; The critics advocate an alternative Inflation Trade-Off?” Federal Reserve Bank of Dallas Southwest Professor Finn E. Kydland, policy—one that would allow output Economy, Issue 3, 1– 4. Carnegie Mellon University; and employment to range freely, as Professor Roy J. Ruffin, Koenig, Evan F. (1995), “Optimal Monetary Policy in an Economy with University of Houston long as inflation holds steady. Since Sticky Nominal Wages,” Federal Reserve Bank of Dallas Economic Executive Editor they believe that supply-side shocks Review, Second Quarter, 24 –31. Harvey Rosenblum make the Phillips curve all but useless Editors as a policy tool, the critics say the Fed Krugman, Paul (1996), “Stable Prices and Fast Growth: Just Say No,” W. Michael Cox, Mine K. Yücel Economist, August 31, 19–22. should look to indicators of inflation ex- Publications Director Kudlow, Lawrence (1997), “In Search of an Enduring Standard,” Wash- Kay Champagne pectations and to sensitive commodity ington Times, March 3, A12. Copy Editors prices for signs that inflation is about to Anne L. Coursey, Monica Reeves accelerate. Meyer, Laurence H. (1997a), “The Economic Outlook and Challenges Design & Production In fact, the Fed has pursued a middle for Monetary Policy” (Remarks presented at the Charlotte Economics Laura J. Bell course. It has taken an eclectic ap- Club, Charlotte, North Carolina, January 16). proach to evaluating strain in the labor ——— (1997b), “The Economic Outlook and Challenges Facing and product markets, neither rigidly en- Monetary Policy” (Remarks presented at the Forecasters Club of New Southwests Economy is published six times annually by the Federal Reserve Bank of Dallas. forcing a speed limit on real GDP York, New York, April 24). The views expressed are those of the authors and should not be attributed to growth nor panicking as the unemploy- Staiger, Douglas, James H. Stock and Mark W. Watson (1997), “The the Federal Reserve Bank of Dallas ment rate has fallen below 6 percent. It NAIRU, Unemployment and Monetary Policy,” Journal of Economic or the Federal Reserve System. Perspectives 11 (Winter): 33–49. Articles may be reprinted on the condition has allowed positive supply shocks to that the source is credited and a copy is be reflected in higher output and em- Yardeni, Edward (1997a), “The Growth-Is-Good Case for Bonds,” provided to the Research Department Deutsche Morgan Grenfell Weekly Economic Analysis, May 5, 1–5. of the Federal Reserve Bank of Dallas. ployment but has restrained growth in Southwest Economy is available free of charge nominal spending. ——— (1997b), “Deep Blue vs. Greenspan,” Deutsche Morgan by writing the Public Affairs Department, Federal Reserve Bank of Dallas, —Evan F. Koenig Grenfell Weekly Economic Analysis, May 19, 1–4. P.O. Box 655906, Dallas, TX 75265-5906, or by telephoning (214) 922-5257.

Page 8 Southwest Economy September/October 1997 BeyondBeyondSSWEWE thethe BorderBorder

Corporate Financing and Governance: An International Perspective

HE DRAMATIC DIFFERENCES Table 1 across countries in how firms Composition of Companies’ Credit Market Debt as a Percentage of are financed and how their Total Credit Market Debt, 1995 managers are held accountable to shareholders have long been United States Germany Japan T the subject of intense academic Total intermediated debt 54 74 77 scrutiny. Only recently, however, have Intermediated debt from banks 17 66 60 these issues become a hot policy topic. Securities 46 26 23

In the United States, there is ongoing NOTE: Credit market debt excludes trade debt. Intermediated debt refers to loans from financial intermediaries. debate about the best methods of Securities include commercial paper, other short-term bills and long-term bonds. financing and governing firms. In Japan SOURCE: OECD Financial Statistics, Part III. and Germany, corporate finance mar- kets have been substantially deregu- lated in recent years. Other countries, such as France and Italy, are consider- ent corporate finance and governance vate managers to act in shareholders’ ing vast privatization efforts and corre- systems in the major industrialized best interests. sponding changes in their financial countries. One of the starkest differences be- systems. And the formerly communist Even the casual observer can see tween the United States and Germany countries are putting in place entirely significant differences in how firms are and Japan is the frequency of such hos- new systems of property rights, busi- financed and governed in the major tile takeovers. Since World War II, for ness law and financial markets. industrialized countries. For example, example, only four successful hostile In deciding how to fashion their U.S. firms rely heavily on corporate takeovers have occurred in Germany. financial markets, policymakers must securities markets to finance invest- They’re almost as rare in Japan. Con- determine the optimal way to organize ment, whereas for Japanese and Ger- versely, in the United States, more than their corporate sectors. In doing so, man firms, intermediaries —principally 10 percent of the 1980 Fortune 500 have they clearly would benefit from under- banks—have traditionally been the since been acquired in a transaction standing the factors behind the differ- most important source of external that was hostile or started off that way. finance. This is illustrated by the rela- Obviously, the threat of a hostile tively small amounts of money raised in takeover is a more important compo- the Japanese and German stock markets nent of the corporate governance Chart 1 (Chart 1) and the much higher share of mechanism in the United States than it Gross Issuance of Public Equity as a external finance that comes from banks is in Germany or Japan. Percentage of GDP, 1995 (Table 1) in Japan and Germany. In contrast, firms in Japan and (espe- The three countries also exhibit big cially) Germany exhibit much higher Percent differences in the primary mechanisms degrees of ownership concentration 1.2 of corporate governance. One impor- than does the United States. Ownership 1 tant mechanism is high ownership con- is very heavily concentrated in German centration. If a firm’s ownership is firms. The five largest shareholders of a .8 concentrated in the hands of a few in- firm own, on average, close to 50 per- .6 vestors, each will have sufficient incen- cent of the firm’s outstanding equity,

.4 tive to invest in acquiring information compared with around 33 percent and monitoring management. Large in Japan and about 25 percent in .2 shareholdings also confer the ability the United States (Chart 2). These large

0 to exert control over management, shareholders in Japanese and German United States Japan Germany through either voting power or board firms are primarily banks, other finan- SOURCES: Federal Reserve Board; Securities Markets in Japan, 1996; Monthly Report of the representation, or both. A second im- cial institutions such as life insurance Deutsche Bundesbank. portant mechanism is the credible threat companies, and nonfinancial corpora- of a hostile takeover, which can moti- tions. Together they hold about 70

Federal Reserve Bank of Dallas Page 9 BeyondBeyondSSWEWE thethe BorderBorder

percent of the outstanding shares of Table 2 German and Japanese firms, in contrast Percentage of Outstanding Corporate Equity Held by Various to the United States, where, despite the Sectors in the United States, Germany and Japan, 1995 fast growth of mutual fund holdings in recent years, direct individual hold- United States Germany Japan ings remain relatively more important Financial institutions 44.5 30.3 35.8 (Table 2). Banks .2 10.3 13.3 Other financial institutions 44.3 20.0 22.5 These differences in finance and governance are not simply accidents Nonfinancial firms 15.0 42.1 31.2 of history but a result of major differ- Individuals 36.3 14.6 22.4 ences in the legal and regulatory en- Foreign 4.2 8.7 10.1 vironments of the countries’ financial Government 0 4.3 .5 systems. The differences are essentially SOURCE: Stephen D. Prowse, “The Structure of Corporate Ownership in Germany,” working paper, 1997. of two kinds. First is the degree to which firms are restricted from utiliz- ing nonbank financing. In contrast to the United States, Germany and Japan vestors taking large, influential equity capital markets are unhindered by reg- have traditionally discriminated heavily stakes in firms and actively monitoring ulatory and legal obstacles. against the development of corporate management. These laws—which in- Speculating about the primary mech- securities markets. The restrictions have clude Glass–Steagall restrictions on anisms of corporate financing and con- revolved largely around stiff securities banks’ holding of corporate equity, trol in such a system is interesting, transaction taxes and cumbersome portfolio regulation of other financial given that these conditions don’t cur- issue-authorization procedures that are institutions, and tax, insider trading and rently exist in any industrialized coun- required for security offerings. Com- corporate bankruptcy laws—have led try. The closest approximation to this bined, they have imposed a heavy bur- to relatively dispersed holdings of emerging model may be the United den on firms seeking nonbank finance, equity in the United States. The absence States in the early 20th century, before domestically or abroad. of such restrictions in Japan and the passage of Glass–Steagall. Second are differences in the legal Germany has encouraged the higher In addition, there is no guarantee and regulatory restraints on large in- levels of ownership concentration in that a convergence of the three coun- vestors being “active” in firms. U.S. laws these countries. tries’ regulatory environments will mean are generally much more hostile to in- Of course, as a financial system’s a convergence in their methods of cor- legal and regulatory environment porate financing and governance, if in- changes, so may methods of corporate stitutional history has any influence on finance and governance. Both Japan the financial system’s structure. For this Chart 2 and Germany have lifted many of the reason, differences in methods of cor- Ownership Concentration of Nonfinancial Firms more onerous restrictions on their porate financing and governance may corporate securities markets in the past persist long after differences in the legal (Percentage of outstanding shares 15 years. This is already reducing their and regulatory environments have dis- held by the five largest shareholders) firms’ dependence on bank lending. appeared. Percent In the United States, there has been —Stephen D. Prowse 50 some relaxation of the numerous re-

40 strictions on financial and nonfinancial corporations taking large equity stakes 30 in other firms. Clearly, there is some long-term 20 convergence of the legal and regulatory

10 environments of these countries. How- ever, this convergence is not toward the 0 German, Japanese or U.S. system as United States Japan Germany they now exist but to an environment in SOURCE: Stephen D. Prowse, “The Structure of Corporate Ownership in Germany,” working which financial institutions and other paper, 1997. investors are free to take large equity stakes in firms and in which corporate

Page 10 Southwest Economy September/October 1997 RegionalRegionalSSWEWE UpdateUpdate

FTER MORE THAN a decade of growth, the Texas struction. Recent changes in state and federal tax law should economy shows few signs of faltering. Federal Reserve further boost housing construction, particularly at the low end Bank estimates indicate that gross state product ex- of the price range. panded at a brisk 4.3 percent annual rate in the first The outlook is for more of the same. The Texas Leading quarter. Although employment growth appears to Index jumped in July, signaling continued expansion. The prob- A have slowed recently, private nonfarm employment in ability of a Texas recession in 1997 is now less than 2 percent. Texas has grown at a 2.9 percent annual rate since the start of Labor market tightness is one factor that could dampen the the year. The employment growth is broad based, with only a forecast. Beige Book contacts continue to report difficulty few noteworthy exceptions—apparel (manufacturing and re- finding workers. Average hourly wages are rising at roughly tailing), chemicals, and computer-related manufacturing. the rate of inflation for most Texas manufacturing industries Despite recent declines in oil prices, employment is up and much faster than inflation for low-wage manufacturing in- sharply in oil and gas extraction and oil field machinery. The dustries. The September 1 increase in the minimum wage industry press reports shortages of skilled workers and a 12- could widen this gap even further. Still, wages are not rising to 18-month backlog for drill pipe. as fast in Texas as they are in the rest of the country, so the Residential construction seems to be heating up again, state should maintain its competitive edge. which is partially offsetting a cooling in nonresidential con- —Lori L. Taylor

Texas Gross State Product Nonfarm Employment Percent change, annualized Index, January 1994 = 100 6 114 Texas 112 5 Louisiana 110 New Mexico 4 United States 108 3 106 104 2 102 1 100 0 98 1994 1995* 1996* 1997:1* 1994 1995 1996 1997 * estimated Hourly Wages in Manufacturing Industries Net Contributions of Components to Change in Leading Index Index, January 1990 = 100 May–July 1997 145 –.58 Average weekly hours 135 Low-wage manufacturing 0 Help-wanted index Texas Stock Index 2.13 125 New unemployment claims .05 –.18 Well permits 115 –.02 Real oil price Other manufacturing 105 U.S. leading index .18 Texas value of the dollar .20 95 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 –1.20 –.80 –.40 0 .40 .80 1.20 1.60 2.00 2.40 Percent

Regional Economic Indicators Further Information Texas employment* Total nonfarm employment* on the Data Texas Private Leading TIPI Construc- Manufac- Govern- service- New For mores information on employment Index total Mining tion turing ment producing Texas Louisiana Mexico data, see “Reassessing Texas Employment 7/97 122.3 126.6 165.2 456.1 1,074.6 1,471.3 5,368.7 8,535.9 1,829.2 707.3 Growth” (Southwest Economy, July/August 6/97 121.0 126.9 164.5 457.5 1,073.8 1,470.8 5,357.2 8,523.8 1,828.9 705.8 1993). For TIPI, see “The Texas Industrial 5/97 121.4 125.9 163.4 456.6 1,073.1 1,475.6 5,347.3 8,516.0 1,827.0 705.4 4/97 120.2 124.7 163.1 450.9 1,072.2 1,474.4 5,328.9 8,489.5 1,828.5 703.4 Production Index” (Dallas Fed Economic 3/97 119.1 124.6 162.5 448.7 1,068.6 1,472.3 5,313.9 8,466.0 1,824.1 702.1 Review, November 1989). For the Texas 2/97 119.4 124.1 162.7 446.5 1,068.7 1,470.2 5,296.2 8,444.3 1,821.9 701.6 Leading Index and its components, see 1/97 118.9 124.3 160.7 437.0 1,064.3 1,467.0 5,276.2 8,405.2 1,820.3 699.8 “The Texas Index of Leading Indicators: 12/96 117.7 124.0 159.4 443.9 1,065.9 1,465.7 5,279.7 8,414.6 1,819.4 698.5 A Revision and Further Evaluation” (Dallas 11/96 118.7 123.8 158.7 445.4 1,065.1 1,460.7 5,271.3 8,401.2 1,818.7 697.0 10/96 117.6 123.3 157.9 442.1 1,061.4 1,455.9 5,237.6 8,354.9 1,816.0 696.2 Fed Economic Review, July 1990). 9/96 117.1 123.0 156.9 438.1 1,057.9 1,450.0 5,179.1 8,282.0 1,815.2 694.7 Online economic data and articles are 8/96 116.7 123.7 156.6 438.1 1,057.2 1,453.8 5,167.5 8,273.2 1,811.5 697.5 available on the Dallas Fed’s Internet Web * in thousands site, www.dallasfed.org.

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