Conversable Economist

Readers who find this blog a useful stimulus for reflection might also be interested in checking the \”Research Highlights\” webpage run by the American Economic Association. I\’m the Managing Editor of the Journal of Economic Perspectives, which is one of the seven journals currently published by the AEA (with an eighth journal scheduled to start publishing next year). Once or twice a week, the Research Highlights page picks a recent article from these journals and offers a short readable overview or an interview with the author. For those interested getting a sense of a wide array of recent economic research, it\’s a good starting point. For a flavor, here\’s a list of the nine most recent entries:

Building trust with buyers (November 21, 2018)
How much do offers of \”satisfaction guaranteed\” improve efficiency in the marketplace?

Making economics transparent and reproducible (November 16, 2018)
The AEA interviews Ted Miguel about the credibility of economics.

Shadow business (November 12, 2018)

Thanksgiving is a day for a traditional menu, and I take a holiday by reprinting this annual column on the origins of the day:

The first presidential proclamation of Thanksgiving as a national holiday was issued by George Washington on October 3, 1789. But it was a one-time event. Individual states (especially those in New England) continued to issue Thanksgiving proclamations on various days in the decades to come. But it wasn\’t until 1863 when a magazine editor named Sarah Josepha Hale, after 15 years of letter-writing, prompted Abraham Lincoln in 1863 to designate the last Thursday in November as a national holiday–a pattern which then continued into the future.

An original and thus hard-to-read version of George Washington\’s Thanksgiving proclamation can be viewed through the Library of Congress website. The economist in me was intrigued to notice that some of the causes for giving of thanks included \”the means we have of acquiring and diffusing useful knowledge … the encrease of science among them and us—and generally to grant unto all Mankind such a degree of temporal prosperity as he alone knows to be best.\”

Also, the original Thankgiving proclamation was not without some controversy and dissent in the House of Representatives, as an example of unwanted and inappropriate federal government interventionism. As reported by the Papers of George Washington website at the University of Virginia.

The House was not unanimous in its determination to give thanks. Aedanus Burke of South Carolina objected that he “did not like this mimicking of European customs, where they made a mere mockery of thanksgivings.” Thomas Tudor Tucker “thought the House had no business to interfere in a matter which did not concern them. Why should the President direct the people to do what, perhaps, they have no mind to do? They may not be inclined to return thanks for a Constitution until they have experienced that it promotes their safety and happiness. We do not yet know but they may have reason to be dissatisfied with the effects it has already produced; but whether this be so or not, it is a business with which Congress have nothing to do; it is a religious matter, and, as such, is proscribed to us. If a day of thanksgiving must take place, let it be done by the authority of the several States.”

As I prepare for a season of pumpkin pie, pumpkin bread (made with cornmeal and pecans), pumpkin soup (especially nice wish a decent champagne) and perhaps a pumpkin ice cream pie (graham cracker crust, of course),  I have been mulling over why the area around Peoria, Illinois, so dominates the production of processed pumpkin.

[In honor of pumpkin pie, I\’m repeating this blog from a year ago.]

The facts are clear enough. As the US Department of Agriculture points out (citations omitted):

In 2016, farmers in the top 16 pumpkin-producing States harvested 1.1 billion pounds of pumpkins, implying about 1.4 billion pounds harvested altogether in the United States. Production increased 45 percent from 2015 largely due to a rebound in Illinois production. Illinois production, though highly variable, is six times the average of the other top eight pumpkin-producing States (Figure 2).

Not only does Illinois produce more pumpkins, but a much larger share of pumpkins from this state end up being processed, rather than used fresh. The USDA reports:

It\’s not really the entire state of Illinois, either, but mainly an area right around Peoria. The University of Illinois extension service writes: \”Eighty percent of all the pumpkins produced commercially in the
U.S. are produced within a 90-mile radius of Peoria, Illinois. Most of those pumpkins are grown for processing into canned pumpkins. Ninety-five percent of the pumpkins processed in the United States are grown in Illinois. Morton, Illinois just 10 miles southeast of Peoria calls itself the `Pumpkin Capital of the World.\’\”

Why does this area have such dominance? Weather and soil are part of the advantage, but it seems unlikely that the area around Peoria is dramatically distinctive for those reasons alone. This also seems to be a case where an area got a head-start in a certain industry, established economies of scale and expertise, and has thus continued to keep a lead. The Illinois Farm Bureau writes: \”Illinois earns the top rank for several reasons. Pumpkins grow well in its climate and in certain soil types. And in the 1920s, a pumpkin processing industry was established in Illinois, Babadoost [a professor at the University of Illinois] says. Decades of experience and dedicated research help Illinois maintain its edge in pumpkin production.\” According to one report, Libby’s Pumpkin is \”the supplier of more than 85 percent of the world’s canned pumpkin.\”

The farm price of pumpkins varies considerably across states, which suggests that it is costly to ship substantial quantities of pumpkin across moderate distances. For example, the price of pumpkins is lowest in Illinois, where supply is highest, and the Illinois price is consistently below the price for other nearby Midwestern states. This pattern suggests that the processing plants for pumpkins are most cost-effective when located near the actual production.

Finally, although my knowledge of recipes for pumpkin is considerably more extensive than my knowledge of supply chain for processed pumpkin, it seems plausible that demand for pumpkin is neither the most lucrative of farm products, nor is it growing quickly, so it hasn\’t been worthwhile for potential competitors in the processed pumpkin market to try to establish an alternative pumpkin-producing hub somewhere else.

As Thanksgiving preparations arrive, I naturally find my thoughts veering to the evolution of demand for turkey, technological change in turkey production, market concentration in the turkey industry, and price indexes for a classic Thanksgiving dinner. Not that there\’s anything wrong with that. [Note: This is an updated and amended version of a post that was first published on Thanksgiving Day 2011.]

The last time the U.S. Department of Agriculture did a detailed \”Overview of the U.S. Turkey Industry\” appears to be back in 2007, although an update was published in April 2014 . Some themes about the turkey market waddle out from those reports on both the demand and supply sides.

On the demand side, the quantity of turkey per person consumed rose dramatically from the mid-1970s up to about 1990, but then declined somewhat, but appears to have made a modest recovery in the last few years The figure below is from the Eatturkey.com website run by the National Turkey Federation.

On the production side, the National Turkey Federation explains: \”Turkey companies are vertically integrated, meaning they control or contract for all phases of production and processing – from breeding through delivery to retail.\” However, production of turkeys has shifted substantially, away from a model in which turkeys were hatched and raised all in one place, and toward a model in which the steps of turkey production have become separated and specialized–with some of these steps happening at much larger scale. The result has been an efficiency gain in the production of turkeys. Here is some commentary from the 2007 USDA report, with references to charts omitted for readability:

\”In 1975, there were 180 turkey hatcheries in the United States compared with 55 operations in 2007, or 31 percent of the 1975 hatcheries. Incubator capacity in 1975 was 41.9 million eggs, compared with 38.7 million eggs in 2007. Hatchery intensity increased from an average 33 thousand egg capacity per hatchery in 1975 to 704 thousand egg capacity per hatchery in 2007.

Some decades ago, turkeys were historically hatched and raised on the same operation and either slaughtered on or close to where they were raised. Historically, operations owned the parent stock of the turkeys they raised while supplying their own eggs. The increase in technology and mastery of turkey breeding has led to highly specialized operations. Each production process of the turkey industry is now mainly represented by various specialized operations.

Eggs are produced at laying facilities, some of which have had the same genetic turkey breed for more than a century. Eggs are immediately shipped to hatcheries and set in incubators. Once the poults are hatched, they are then typically shipped to a brooder barn. As poults mature, they are moved to growout facilities until they reach slaughter weight. Some operations use the same building for the entire growout process of turkeys. Once the turkeys reach slaughter weight, they are shipped to slaughter facilities and processed for meat products or sold as whole birds.

Turkeys have been carefully bred to become the efficient meat producers they are today. In 1986, a turkey weighed an average of 20.0 pounds. This average has increased to 28.2 pounds per bird in 2006. The increase in bird weight reflects an efficiency gain for growers of about 41 percent.\”

The 2014 report points out that the capacity of eggs per hatchery has continued to rise (again, references to charts omitted):

\”For several decades, the number of turkey hatcheries has declined steadily. During the last six years, however, this decrease began to slow down. As of 2013, there are 54 turkey hatcheries in the United States, down from 58 in 2008, but up from the historical low of 49 reached in 2012. The total capacity of these facilities remained steady during this period at approximately 39.4 million eggs. The average capacity per hatchery reached a record high in 2012. During 2013, average capacity per hatchery was 730 thousand (data records are available from 1965 to present).\”

U.S. agriculture is full of examples of remarkable increases in yields over perionds of a few decades, but they always drop my jaw. I tend to think of a \”turkey\” as a product that doesn\’t have a lot of opportunity for technological development, but clearly I\’m wrong. Here\’s a graph showing the rise in size of turkeys over time from the 2007 report.

The production of turkey remains an industry that is not very concentrated, with three relatively large producers and then more than a dozen mid-sized producers. Here\’s a list of top turkey producers in 2015 from the National Turkey Federation:

Given this reasonably competitive environment, it\’s interesting to note that the price markups for turkey–that is, the margin between the wholesale and the retail price–have in the past tended to decline around Thanksgiving, which obviously helps to keep the price lower for consumers. However, this pattern may be weakening over time, as margins have been higher in the last couple of Thanksgivings  Kim Ha of the US Department of Agriculture spells this out in the \”Livestock, Dairy, and Poultry Outlook\” report of November 2018.. The vertical lines in the figure show Thanksgiving. She writes: \”In the past, Thanksgiving holiday season retail turkey prices were commonly near annual low points, while wholesale prices rose. … The data indicate that the past Thanksgiving season relationship between retail and wholesale turkey prices may be lessening.\”

In the past, the US turkey industry has at some times suffers from outbreaks of HPAI
(Highly Pathogenic Avian Influenza): for discussion of the 2015 outbreak, see the November 17, 2015 issue of the \”Livestock, Dairy, and Poultry Outlook\” from the US Department of Agriculture, Kenneth Mathews and Mildred Haley offer some details. But for Thanksgiving 2018, supply seems to have remained strong and wholesale turkey prices have stayed low.

Anyway, the starting point for measuring inflation is to define a relevant \”basket\” or group of goods, and then to track how the price of this basket of goods changes over time. When the Bureau of Labor Statistics measures the Consumer Price Index, the basket of goods is defined as what a typical U.S. household buys. But one can also define a more specific basket of goods if desired, and since 1986, the American Farm Bureau Federation has been using more than 100 shoppers in states across the country to estimate the cost of purchasing a Thanksgiving dinner. The basket of goods for their Classic Thanksgiving Dinner Price Index looks like this:

The cost of buying the Classic Thanksgiving Dinner actually declined by a bit in 2018, fallingfrom to $49.12 in 2018 to $48.90 in 2018. The top line of the graph that follows shows the nominal price of purchasing the basket of goods for the Classic Thanksgiving Dinner. The lower line on the graph shows the price of the Classic Thanksgiving Dinner adjusted for the overall inflation rate in the economy. The lower line is relatively flat, which means that inflation in the Classic Thanksgiving Dinner has actually been a pretty good measure of the overall inflation rate.

I sometimes run across articles that offer additional follow-up on topics about which I\’ve previously posted, or stories in the news that remind me of earlier posts. Here, I\’ll just offer short follow-ups on an eclectic set of four topics:

• The Scandinavian style of capitalism, 
• Economic gains from in equal opportunity
• The news about Brexit
• Possible systemic risks of the risks of leveraged lending

1)  \”The Scandinavian Style of Capitalism\” (November 5, 2018)

I wrote a few weeks ago about the actual specific attributes of the style of capitalism practiced in countries of northern Europe. (Hint: It isn\’t \”socialism,\” and it has a number of traits of which many American supporters of a Scandinavian approach seem largely unaware.) A reader forwarded to me this report Sweden\’s Ministry of Finance  called \”The Swedish Model\” (June 20, 2017).

Some of the report is the kind of stuff that any government says when it is not-too-subtly praising itself. It\’s not incorrect, but it does tend to sidestep concerns and problem. From the perspective of an an American who often hears casual references to the Swedish model or Scandinavian model, it\’s interesting to consider the emphasis that the report puts on a shared social responsibility. Here\’s a representative paragraph:

\”The distinguishing characteristics of the Swedish labour market are coordinated wage formation, an active labour market policy and effective unemployment insurance. The fundamental premise is that individuals should contribute through work and be willing to adjust to new tasks. Provided that individuals perform this part of the social contract, they qualify for rights in the form of income-related social security, and, after needs assessment by the Public Employment Service, active initiatives to facilitate the return to work after having become unemployed. In addition, there is a certain level of financial security for people who do not qualify for income-related social security benefits. The social partners also provide a large portion of support in connection with unemployment through various career readjustment agreements.\”

Some of those who favor what they think of as a Scandinavian approach to labor markets tend to emphasize the government benefits, but not to put an equal and counterbalancing emphasis on the responsibility of individuals to adjust to new tasks and careers. The report also emphasizes the importance in the Swedish model of a fiscal policy that \”is sustainable over the long term … with surplus targets, expenditure ceilings, a municipal balanced budget requirement and rigorous budget process,\” as well as the central importance of promoting competitiveness in open international trade
2) \”Equal Opportunity and Economic Growth\” (August 1, 2012)

Back in 2012, I noted a study of how improvements in equal opportunity benefit economic growth, because an economy that makes fuller use of its human resources will be larger. For an illustration of shifts toward more equal opportunity, Pete Klenow offered this table. Based on joint research with others, he argued that about 15-20% of total US growth from 1960 to 2008 can be explained by women and African-Americans investing more in human capital and working in high-skill occupations.

For those who would like to see the underlying research behind this result, the most recent (April 6, 2018) version of the research paper is available at Klenow\’s website. Their current estimate is that \”[a]bout one-quarter of growth in aggregate output per person over this period [from 1960 to 2010] can be explained by the improved allocation of talent.\” There\’s a cautionary insight her about how how academic research really works. The preview of these findings from six years ago, back in 2012, has mostly the same bottom line result as the current paper. But the authors have spent years writing and revising to sharpen the analysis and to address detailed questions that have been raised. And the paper isn\’t published yet.

3) The United Kingdom and the European Union have agreed on the text of a draft agreement for how the UK might leave the EU. The news stories caused me to reflect on two earlier posts. In
\”Seven reflections on Brexit\” (June 27, 2016), I offered some thoughts in the immediate aftermath of the Brexit vote. For example, here was my first point:

1) The Brexit vote seemed to me a strangely American moment. Some of the lasting slogans handed down from the American revolution against England are \”no taxation without representation\” and \”don\’t tread on me.\” Thus, for an American there was some historical irony in hearing many of the British argue, in effect, that there should be \”no regulation without representation,\” or perhaps \”no legislation without representation.\” There was similar irony in hearing some of the British turn loose their \”don\’t tread on me\” spirit while railing against annoying but in some sense small-scale regulatory impositions from the central power, like rules that sought to standardize shapes and sizes for fruit and vegetable produce, or the rules with force of law that sales of loose and packaged good use only metric measurements. I found myself half-expecting some \”Leave\” advocates to start quoting the US Declaration of Independence: \”When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature\’s God entitle them …\”

For a discussion of the economic studies about Brexit options and their effects, see \”Brexit: Getting Concrete about Next Steps\” (August 2, 2016) and \”Brexit: Still a Process, Not Yet a Destination\” (November 17, 2017).

4) \”Corporate Debt and Leveraged Loans: Financial Snags Ahead?\” (September 21, 2018)

Stop me if you\’ve heard this story before. Certain loans look too risky for any bank to make on its own. So groups of lenders combine to make such loans, and then repackage groups of these loans as complex financial securities, and then resell the in pieces to investors all over the economy.  Just which financial institutions are are exposed to the downside risks is unclear. But we do know that the volume of these loans is growing fast, while the credit standards applied to granting such loans has been declining. Although this general description seems as if it could apply to the wave of lending in US housing markets in the lead-up the Great Recession, it also applies to the current wave of what is called \”leveraged lending.\”  For an earlier post on the subject, see \”Leveraged Loans: A Danger Spot?\” (October 4, 2014).

Three economists from the IMF, Tobias Adrian, Fabio Natalucci, and Thomas Piontek, have wrtten a recent blog post \”\”Sounding the Alarm on Leveraged Lending\” (November 15, 2018). Among other concerns, they offer this figure:

Similarly, the Office of Financial Research has just published its Annual Report to Congress 2018, \”which presents its assessment of the state of the U.S. financial system, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.\” Its overall assessment is that \”risks to U.S. financial stability are still in a medium range overall.\” But it highlights leveraged lending as an area of concern. The report notes:

\”Rapid growth in leveraged lending is a concern. These commercial loans, often used by borrowers with credit ratings below investment grade for buyouts, acquisitions, or capital distributions, can leave borrowers highly indebted. Strong investor demand for these higher-yielding loans is behind the rapid growth. Less creditworthy corporations took advantage of that demand by seeking more funding in leveraged loan markets. As a result, more than $1 trillion of leveraged loans are outstanding. That is more than 11 percent of all U.S. nonfinancial debt — a record high. With the growth in leveraged lending has come a deterioration in the credit quality of newly issued loans. One sign of this decline is the high share of covenant-lite loans … Covenants are restrictions placed on debt-issuing firms meant to increase the likelihood of payment. Another sign of deterioration in underwriting quality is that more than half of all leveraged loans issued are rated B+ or lower (that is, highly speculative). \”

Chicago Fed Letter (2018, No. 405).

Polacek offers a nice concrete example of how a CAT bond works. The American Family Mutual Insurance Company wanted to be reinsured if it experienced very high losses due to severe thunderstorms and tornadoes in the United States. Thus, in November 2010 it set up a \”special purpose vehicle\” called Mariah Re Ltd. to issue a CAT bond.

It worked like this. Investors in the CAT bond put up $100 million. That money was immediately invested in US Treasury securities. In addition, American Family Mutual Insurance Company agreed to pay the investors an additional return of 6.25% per year, over a three-year period. If there were no excessive losses from thunderstorms during those three years, the CAT bond would end, and the $100 million would be refunded to the original investors.

However, every CAT bond has built into it an \”attachment point,\” which specifies when a certain large-scale event has occurred. It might refer to an earthquake of a certain size, or to a certain kind of storm causing at least a certain magnitude of losses. In the case of American Family Mutual Insurance Company and Mariah Re, the \”attachment point\” occurred \”if estimated losses to the P&C insurance industry from severe thunderstorms and tornadoes across the U.S. exceeded $825 million … After the $825 million attachment point was reached, AFMI would receive $1 in compensation for every $1 of additional covered losses up to the $100 million limit.\” A third party is designated in advance to decide if the \”attachment point\” has been reached: in this case, the third party was a company called AIR Worldwide.

This example helps to clarify the risk-sharing properties of a CAT bond. For the insurance company, issuing a CAT bond is a way of purchasing re-insurance against extreme losses. But it has some advantages over purchasing reinsurance. Because the money is sitting in an account, there is no danger that the reinsurance company might be unable to pay. Also, a CAT bond can be set up to cover a period of several years, while a reinsurance purchase is typically for one year. Finally, because lots of investors like pension funds, mutual funds, and hedge funds can buy CAT bonds, the pool of funds available for reinsurance becomes a lot larger than the available capital of reinsurance companies taken alone

For investors, a CAT bond offers a rate of return with a degree of risk, with the nice property that the occurrence of extreme insurance events is typically not much correlated with other risks in financial markets. In this particular case of American Family Mutual Insurance Company and Mariah Re, the US experienced a huge number of costly and deadly tornadoes in 2011, leading to insured losses of $954 million. This total was more than $100 million above the attachment point of $825 million, so that investors in this CAT bond lost all of the $100 million they had invested. But over time, the actual returns from investing in CAT bonds have been attractive.

This figure shows the growth in total issuance of catastrophe bonds over time, now at about $25 billion worldwide.

One of the most interesting uses of CAT bonds is not by insurance or reinsurance companies, but by governments. Payouts from these CAT bonds often triggered by measures of the strength of the covered catastrophe—such as an earthquake’s magnitude or a hurricane’s wind speed and barometric pressure. As a result, it is typically quite clear when a trigger has been exceeded, and the fund to cover the catastrophe can be released very quickly, when they are needed. In the US, the California Earthquake Authority (CEA) and the Florida Hurricane Catastrophe Fund (FHCF) issue catastrophe bonds. \”The Caribbean Catastrophe Risk Insurance Facility (CCRIF)—developed with the assistance of the World Bank—has used CAT bonds … After Hurricane Matthew struck the Caribbean in the fall of 2016, the CCRIF paid out a little over $20 million to Haiti and almost $1 million to Barbados within 14 days after the triggering event.\”

A common concern about any new financial instrument is that it will work until investors take substantial and losses, and then it may fade away. Thus, it is a good sign for the fundamental health of catastrophe bonds as a useful financial innovation that even after experiencing very large losses for investors in 2017, it kept growing in 2018. Polacek writes:

Mushrooms are a relatively small US agricultural crop, with total production of about $1.2 billion in the 2017-2018 growing year. But they do illustrate some economic lessons, including how a local area that develops a specialization in a certain product can be hard to dislodge, and how the rise of China is reshaping global production in so many ways.

US mushroom production has for a long time been very geographically concentrated. The town of Kennett Square in southeastern Pennsylvania bills itself as the Mushroom Capital of the World, because about half of all US mushroom production happens in the surrounding area of Chester County.

The story here goes back to 1885, and to a florist named William Swayne who lived in Kennett Square. Swayne grew a lot of carnations, which required raised beds. He pondered whether it might be possible to grow a cash crop in the space under those raised beds. Mushrooms had been domesticated in France and England in the middle of the 19th century. Swayne sent away to England for mushroom spores, and began growing them. The demand was high enough that he built a \”mushroom house,\” an enclosed building designed to grow only mushrooms. Other local farmers took note, and the Mushroom Capital of the World became established.

From an economic point of view, an obvious question is why mushroom production remains so concentrated in Chester County more than 120 years later. After all, the basic materials for growing mushrooms like compost from vegetative material (like straw and hay), along with animal manure, are not hard to find. The climate of southeastern Pennsylvania provides a usefully cool ground temperature in fall, winter, and spring, but there are many other locations with similar temperatures.

But from the perspective of global mushroom production, this sixfold increase in US mushroom production in the last half-century is only a modest part of the story. The growth of China\’s economy has led an extraordinary rise in global mushroom production in the last 20 years. Daniel J. Royse , Johan Baars and Qi Tan provide  background in \”Current Overview of Mushroom Production in the World.\” which appears as Chapter 2 in the 2017 book Edible and Medicinal Mushrooms: Technology and Applications, edited by Diego Cunha Zied and Arturo Pardo-Giménez. As they note (references omitted):

World production of cultivated, edible mushrooms has increased more than 30‐fold since 1978 (from about 1 billion kg in 1978 to 34 billion kg in 2013). This is an extraordinary accomplishment, considering the world’s population has increased only about 1.7‐fold during the same period (from about 4.2 billion in 1978 to about 7.1 billion in 2013). Thus, per capita consumption of mushrooms has increased at a relatively rapid rate, especially since 1997, and now exceeds 4.7 kg annually (vs 1 kg in 1997; Figure 2.2). …

China is the main producer of cultivated, edible mushrooms (Figure 2.3). Over 30 billion kg  of mushrooms were produced in China in 2014, and this accounted for about 87% of total production. The rest of Asia produced about 1.3 billion kg, while the EU, the Americas, and other countries produced about 3.1 billion kg.

Here\’s a figure showing growth of mushroom production vs. world population.

And here\’s a figure showing global mushroom production by location:

For sales of fresh mushrooms within the US and Canada, Kennett Square doesn\’t appear to be under immediate threat. But a 2010 report of the US International Trade Commission pointed out that the US became a net importer of processed mushrooms–typically grown in China–back in 2003-2004.

Fifty years ago in 1968, Milton Friedman\’s Presidential Address to the American Economic Association set the stage for battles in macroeconomics that have continued ever since. The legacy of the talk has been important enough that in the Winter 2018 issue of the Journal of Economic Perspectives, where I work as Managing Editor, we published a three-paper symposium on \”Friedman\’s Natural Rate Hypothesis After 50 Years.\”

• \”Friedman\’s Presidential Address in the Evolution of Macroeconomic Thought,\” by N. Gregory Mankiw and Ricardo Reis (pp. 81-96)
• \”Should We Reject the Natural Rate Hypothesis?\” by Olivier Blanchard (pp. 97-120)
• \”Short-Run and Long-Run Effects of Milton Friedman\’s Presidential Address,\” by Robert E. Hall and Thomas J.Sargent (pp. 121-34)

Likewise, the Review of Keynesian Economics has committed now most of its October 2018 issue to a nine-paper symposium on the issues raised by Friedman\’s presidential address. The first two papers in the issue, by Robert Solow and Robert J. Gordon, are freely available on-line, with the rest of the issue requiring a library subscription. Here, I\’ll focus mainly on Solow\’s comments.

Robert Solow is a notable player in these disputes: in particular, in his 1960 paper with Paul Samuelson, \”Analytical Aspects of Anti-Inflation Policy\” (American Economic Review, 50:2, pp. 177-194). In an essay in the Winter 2000 issue of the Journal of Economic Perspectives, \”Toward a Macroeconomics of the Medium Run,\”  Solow addressed this question of thinking about macroeconomic policy in the short- and the long-run. He wrote:

I can easily imagine that there is a “true” macrodynamics, valid at every time scale. But it is fearfully complicated, and nobody has a very good grip on it. At short time scales, I think, something sort of “Keynesian” is a good approximation, and surely better than anything straight “neoclassical.” At very long time scales, the interesting questions are best studied in a neoclassical framework, and attention to the Keynesian side of things would be a minor distraction. At the five-to-ten-year time scale, we have to piece things together as best we can, and look for a hybrid model that will do the job.

In this most recent essay, \”A Theory is a Sometime Thing,\” Solow pushes this idea of medium-run thinking harder. He acknowledges that if a central bank can only cause the interest rate and unemployment rate to shift for a year or two, in the short-run before a rebound to what is determined in the long run, then when problems of lags in timing are included, macroeconomic policy might be dysfunctional. But if a central bank can affect the interest rate and the unemployment rate for a medium-run period of, say 5-7 years, then even with some uncertainty and lags, macroeocnomic policy may be quite relevant and possible. At one point, Solow writes: \”The medium run is where we live.\”

On the issue of interest rates, Solow points out in the late 1970s and early 1980s, Paul Volcker\’s actions pushed up interest real interest rates substantially, such that the real federal funds interest rate \”rose sharply to about 5 percent and fluctuated around that level for the next six years …This sustained 5 percentage point increase in the real funds rate was not a random event. It was a deliberate intervention, designed to end the ‘double-digit’ inflation of the early 1970s, and it did so, with real side-effects. … So the Fed was in fact able to control (‘peg’) its real policy rate, not for a year or two but for at least six years, certainly long enough for the normal conduct of counter-cyclical monetary policy to be effective. 

The history of the Bernanke/Yellen Fed is more complicated ….. The Fed was apparently able to lower the real ten-year Treasury bond rate for half a dozen years, 2011–2016. Of course there are many influences on the real long interest rate; it is at least plausible that large Fed purchases contributed to the outcome that the Fed was consciously seeking. The difference between ‘a year or two’ and ‘half a dozen years’ is not a small matter.

What about the natural rate of unemployment? One implication of Friedman\’s arguments was that if the government used macroeconomic policy in an attempt to hold the unemployment rate below it\’s natural rate in the long-run, it would lead to surges of ever-higher inflation. As Solow notes, in the 1970s and early 1980s, sharp drops in the unemployment rate do seem associated with rising inflation. But the main story about inflation in the last 20-25 years is that it doesn\’t seem to react to much: it doesn\’t get a lot higher or a lot lower as the unemployment rate rises and falls. Solow goes so far as to claim: \”[T]there is no well-defined natural rate of unemployment, either statistically or conceptually.\”

For a more positive gloss on the legacy of Friedman\’s argument and its applications to modern macroconomics, I commend your attention to the JEP articles listed above. Here, Solow ends  his note with the kind of elegant rhetorical flourish that he brings to so much of his writing:

\”A few major failures like those I have registered in this note may not be enough for a considered rejection of Friedman\’s doctrine and its various successors. But they are certainly enough to justify intense skepticism, especially among economists, for whom skepticism should be the default mental setting anyway. So why did those thousand ships sail for so long, why did those ideas float for so long, without much resistance? I don\’t have a settled answer.

One can speculate. Maybe a patchwork of ideas like eclectic American Keynesianism, held together partly by duct tape, is always at a disadvantage compared with a monolithic doctrine that has an answer for everything, and the same answer for everything. Maybe that same monolithic doctrine reinforced and was reinforced by the general shift of political and social preferences to the right that was taking place at about the same time. Maybe this bit of intellectual history was mainly an accidental concatenation of events, personalities, and dispositions. And maybe this is the sort of question that is better discussed while toasting marshmallows around a dying campfire.\”

Here\’s a Table of Contents for the relevant papers in the October 2018 issue of the Review of Keynesian Economics:

• \”Milton Friedman\’s presidential address at 50,\” by Thomas Palley and Matías Vernengo
• \”A theory is a sometime thing,\” by Robert Solow
• \”Friedman and Phelps on the Phillips curve viewed from a half century\’s perspective\” by Robert J. Gordon
• \”Why the fuss? Friedman (1968) after 50 years,\” by David Laidler
• \”The role of financial policy,\” by Roger E.A. Farmer
• \”Why is labour market adjustment so slow in Friedman\’s presidential address?\” by James Forder
• \”Recovering Keynesian Phillips curve theory: hysteresis of ideas and the natural rate of unemployment,\” by Thomas Palley
• \”A short story of the Phillips curve: from Phillips to Friedman… and back?\” by Antonella Stirati and Walter Paternesi Meloni
• \”The wrong track also leads someplace: Milton Friedman\’s presidential address at 50,\” by Servaas Storm
• \”The relationship between inflation and unemployment: a critique of Friedman and Phelps,\” by Louis-Philippe Rochon and Sergio Rossi

Along with the JEP papers mentioned earlier, those interested in the subject may also want to consult the paper by Edward Nelson, “Seven Fallacies Concerning Milton Friedman’s `The Role of Monetary Policy,\’\” *Finance and Economics Discussion Series 2018-013, Board of Governors of the Federal Reserve System,

Imagine two people who have seemingly equal skills and background. They go to work for two different companies. However, one \”superstar\” company grows much faster, so that wages and opportunities in that company also grow much faster. Or they go to work in two different cities. One \”superstar\” urban economy grows much faster, so that wages and opportunities in that city also grow faster.

Of course, such patterns of unequal growth have always existed  to some extent. When evaluating a potential employer or location choice, people  have always taken into account the potential for joining a superstar performer. The interesting question is whether the gap between superstar and ordinary firms, or between superstar and ordinary cities, has been growing or changing over time. For example, some argue that the rise of superstar firms, and the resulting rise in between-firm performance and labor compentiation, can explain most of the rise in US income inequality.

The McKinsey Global Institute has a nice report summarizing past evidence and offering new evidence of their own in Superstars: The Dynamics of Firms, Sectors, and Cities Leading the Global Economy (October 2018). It\’s written by a team led by James Manyika, Sree Ramaswamy,  Jacques Bughin, Jonathan Woetzel, Michael Birshan, and Zubin Nagpal. Short summary: Superstar firms and cities do seem to be widening their economic leadership gap, with the evidence that certain sectors are superstars seems weaker.

For superstar firms, the report notes:

\”For firms, we analyze nearly 6,000 of the world’s largest public and private firms, each with annual revenues greater than $1 billion, that together make up 65 percent of global corporate pretax earnings. In this group, economic profit is distributed along a power curve, with the top 10 percent of firms capturing 80 percent of economic profit among companies with annual revenues greater than $1 billion. We label companies in this top 10 percent as superstar firms. The middle 80 percent of firms record near-zero economic profit in aggregate, while the bottom 10 percent destroys as much value as the top 10 percent creates. The top 1 percent by economic profit, the highest economic-value-creating firms in our sample, account for 36 percent of all economic profit for companies with annual revenues greater than $1 billion. Over the past 20 years, the gap has widened between superstar firms and median firms, and also between the bottom 10 percent and median firms. … The growth of economic profit at the top end of the distribution is thus mirrored at the bottom end by growing and increasingly persistent economic losses …\”

Some other patterns are that the superstar firms \”come from all sectors and regions and include global banks and manufacturing companies, long-standing Western consumer brands, and fast-growing US and Chinese tech firms. The sector and geographic diversity of firms in the top 10 percent and the top 1 percent by economic profit is greater today than 20 years ago.\” Along with being more profitable, superstar firms spend more on R&D and on intangible investments like intellectual property, software, and brand value. In additinon, the rate of movement (or the \”churn\”) in and out of the deciles doesn\’t seem to have changed much over time. 

\”In the top 1 percent by economic profit, only one out of every six of today’s superstar firms has been there for the past three decades. They are mostly American and European consumer goods and technology firms that have survived, often through reinvention and adaptation to a changing environment and sustained investment, and they own some of the world’s most familiar brands.26 They include Altria, Coca-Cola, Intel, Johnson & Johnson,  Merck, Microsoft, Nestle, and Novartis. They are joined by several other firms that have stayed in the top ranks for two-thirds or more of the past 30 years and that come from a broader set of regions and sectors. These include firms such as Samsung, Toyota, and Walmart, and they make up another one-sixth of the top 1 percent.\”

The analysis also identifies 50 superstar cities, with a map below.

\”Fifty cities are superstars by our definition … The 50 cities account for 8 percent of global population, 21 percent of world GDP, 37 percent of urban high-income households, and 45 percent of headquarters of firms with more than $1 billion in annual revenue. The average GDP per capita in these cities is 45 percent higher than that of peers in the same region and income group, and the gap has grown over the past decade. … The growth of superstar cities is fueled by gains in labor income and wealth from real estate and investor income, yet many show higher rates of income inequality within the cities than peers. … Of the 50 superstar cities, 31 are ranked among the most globally integrated cities, 27 among the world’s 50 most innovative cities, 26 among the world’s top 50 financial centers, and 23 among the world’s 50 “digitally smartest” cities. Twenty-two are national and regional capitals, while 22 are among the world’s largest container ports.\” 

For individuals thinking about potential employers, and for individuals and firms thinking about location decisions, it\’s useful to consider the potential gains of being connected to a superstar firm or city.

For a national economy, a different question arises. What is the \”special sauce\” that superstar companies and cities are using to achieve their outsized and growing levels of productivity and income? Companies and cities will always differ, or course. But the rising advantage of superstars raises a question of how at least some of those practices and policies might be more broadly disseminated across the rest of the economy.

In September 2017, Amazon announced that it was planning to set up a second headquarters. It published a \”Request for Proposal\” that began:

Amazon invites you to submit a response to this Request for Proposal (“RFP”) in conjunction with and on behalf of your metropolitan statistical area (MSA), state/province, county, city and the relevant localities therein. Amazon is performing a competitive site selection process and is considering metro regions in North America for its second corporate headquarters.

The RFP suggested that within broad parameters, the search was wide-open. It is full of comments like \” All options are under consideration\” and \”We encourage testimonials from other large companies\” and \”Tell us what is unique about your community.\” The quick overview of its requirements looked like this:

In choosing the location for HQ2, Amazon has a preference for:

• Metropolitan areas with more than one million people
• A stable and business-friendly environment
• Urban or suburban locations with the potential to attract and retain strong technical talent
• Communities that think big and creatively when considering locations and real estate options

HQ2 could be, but does not have to be:

• An urban or downtown campus
• A similar layout to Amazon’s Seattle campus
• development-prepped site. We want to encourage states/provinces and communities to think creatively for viable real estate options, while not negatively affecting our preferred timeline

Several hundred cities heard what Amazon said, and sent in proposals. Many of those were no-hopers, of course. Still, now Amazon has announced its choices: New York (technicallly Long Island City) and DC (technically Arlington, Virginia). Wow, some really radical open-minded out-of-the-box thinking there! It seems as if a more accurate list of criteria for Amazon\’s Request for proposal might have had three elements.

1) Should be an easy commute from one of the homes of Jeff Bezos, CEO of Amazon. Scott Galloway offers a useful info-graphic here:

2) Should either be near the nation\’s major center of government or near the nation\’s major center of the financial industry. Or maybe we\’ll just do both.

3) Should be one of the top two cities for total number of people already employed in computer and mathematical jobs. Alan Berube at Brookings offers this useful table.

There\’s nothing wrong with these actual criteria. Having a corporate headquarters near the residence of the CEO, especially when the CEO is as closely identified with the company as Bezos is with Amazon, is a long-standing practice. There are obvious advantages to being in New York and DC.

But I do wonder if the folks at Amazon have any clue about how annoyingly cozy this looks to the several hundred other cities that took the time to put in bids. Sure, places like Columbus, Ohio, or Indianapolis, Indiana can get a pat on the head for being on the \”short list.\”  The day before the decision was announced, the major of Jersey City tweeted: \”Of course #jerseycity would benefit if it’s in NY but I still feel this entire Amazon process was a big joke just to end up exactly where everyone guessed at the start. No real social impact on a city, no real transformation, no inspiring young residents that never had this\” The next time Amazon starts talking with cities about locating a facility anywhere, this process will be remembered.

In the RFP, Amazon talked a good game about the importance of a \” local government structure and elected officials eager and willing to work with the company.\” It talked about a fast permit process for building, and about the importance of smoothly functioning transportation infrastructure. It Amazon becomes mired in the local politics, regulatory disputes, and traffic jams of New York and DC, it shouldn\’t expect much sympathy from hundreds of other places across the country.