Tuesday, March 3, 2015

Causing the Great Compression

This blog post mostly comes from some longer stuff I'm working on, but I think it's interesting and blog-worthy, so here it goes.

The greatest decline in income inequality in the history of the United States happened between 1930 and 1950. The nation went from Great Gatsby to Ozzie and Harriet. Economists call it the "Great Compression." What caused it?

First, some quick background. Broadly speaking, there are two schools of thought in economics research on inequality.

One school, associated with economists like David Autor, Alan Krueger, and Lawrence Katz, likes to think about inequality as being determined by relative supply and demand for different categories of labor -- such as skilled versus unskilled, college-educated versus not, cognitive white-collar versus repetitive manual.

Another school, associated with economists like David Card, David Lee, and John DiNardo, puts its focus on institutions that affect labor markets -- such as the decline in unionization and in the real minimum wage, the rise of international trade and immigration, social norms about executive compensation, and financial deregulation.

That's a crude and incomplete picture of how economists think about inequality, and the two schools are mostly complementary. But it sets up an intuitive contrast when we turn to look at the Great Compression: To what extent was it caused by supply-and-demand, and to what extent was it caused by institutions?

Economists don't really know, or at least, that's my assessment of the state of knowledge on this topic. Claudia Goldin and Robert Margo, the economists who came up with the term "Great Compression," point to both supply-and-demand and institutions. On the supply-and-demand front, for instance, the GI Bill increased the relative supply of skilled and educated workers in the 1950s and the rise of manufacturing increased demand for unskilled labor. For institutions, they look to the National Industrial Recovery Act and the National War Labor Board.

Here's where I come in.

Using data from the NBER's Macrohistory database, I was able to construct monthly estimates of the gap in earnings between skilled and unskilled workers in construction for the 1930s and 1940s. I also found the gap in hours worked between skilled and unskilled workers in manufacturing for the same period. "Skilled" is defined by a trade -- in construction, for instance, it's a bricklayer, carpenter, or ironworker.

The advantage with my data is that I have more frequent observations, so I can see more finely what is going on in wages and hours than what's been written on the Great Compression before me. So let's look at the wage premium, interpreting the scale as a percentage difference (e.g., 0.8 = 80%) in wages between skilled and unskilled workers:

The wage gap in construction shrunk 10 percentage points in the months immediately following the passage of the National Industrial Recovery Act in 1933, a law which Goldin and Margo suggest should be important to understanding the Great Compression. The change in relative wages resulted from a sharp increase in the unskilled construction wage in 1933, with relatively little change in the skilled wage over this period. Then the gap remained stable from 1934 until 1939. And then, from 1940 to 1950, it declined 25 percentage points.

Let's now take a look at hours, again interpreting the scale as a percentage difference between skilled and unskilled workers:

What we should notice is that at exactly the same time as the wage gap collapses, the hours gap goes from -0.06 to +0.04. That is, in the fall of 1933, skilled workers' hours rose 10 percentage points relative to unskilled workers' hours. Then, once the wage gap starts declining again in 1940, the hours gap starts to rise.

Why do hours matter to this story? Simply put, hours allow us to distinguish between the causes of the compression, between supply-and-demand and institutions.

A change in institutions towards ones that reduce the wage premium should also increase the hours premium. For intuition, if you're basically being forced to pay unskilled workers more than you would have, you might respond by reducing unskilled workers' hours. Another related explanation are labor rules that simultaneously restrict maximum pay and maximum hours, which would tend to produce the same result as before.

Contrastingly, a change in supply-and-demand that favors unskilled labor over skilled labor should reduce the wage premium but decrease the hours premium. For intuition, if the rise of the assembly line makes unskilled workers more productive, you'd want to get as many hours as you can out of them.

So we have the predictions for hours going in opposite directions. Up would suggest institutions, down would suggest supply-and-demand. And, of course, we see that relative hours of skilled workers rose. Moreover, that rise occurs in the shadow of the National Industrial Recovery Act -- which, we've already said, should point us towards institutions.

Second, we can look at the much more gradual compression in the 1940s. Again, skilled workers gain hours over unskilled workers. What's going on in this period? As Goldin and Margo explain, the National War Labor Board (see earlier poster) is regulating wage increases, resulting in a compression.

Both periods of compression in the 1930s and the 1940s, then, seem to fit the pattern of institutions rather than supply-and-demand. If relative supply-and-demand drove the compression, we'd expect to see hours of unskilled workers gaining on skilled workers' hours. Instead, we see the reverse. When the wage gap between skilled and unskilled workers dwindled, firms shifted towards skilled workers -- a phenomenon that makes sense, really, only if the wage compression is imposed on firms, and firms respond through hours.

There's a lot more to be done on this, for sure. But this is, I think, some neat new evidence that helps to pin down the critical role of institutions in the Great Compression.

Monday, March 2, 2015

What's the Actual Lower Bound?

Economists had believed that it was effectively impossible for nominal interest rates to fall below zero. Hence the idea of the "zero lower bound." And they had a good reason for believing that. Currency pays a zero nominal interest rate -- that is, a dollar bill today is a dollar bill tomorrow, no more and no less --  and therefore any attempt to lower interest rates on bank deposits below zero will merely result in depositors withdrawing their money and putting it into currency.

Well, so much for that theory. Interest rates are going negative all around the world. And not by small amounts, either. $1.9 trillion dollars of European debt now carries negative nominal yields, and the overnight interest rate in Swiss franc is around -1 percent annually.

How can we make sense of that? If people aren't converting deposits to currency, one explanation is that it's just expensive to carry or to store any significant amount of it. Therefore, the true lower bound is some negative number: zero minus the cost of currency storage.

You're only better off cashing out your bank deposits when the deposit rate is larger than the cost of storage.  For example, if it costs you 2 percent annually to store your money in currency, you'll keep your money in the bank even if the bank charges you 1 percent annually.

That's what Greg Mankiw was getting at when he said this great line about the effects of negative nominal interest rates: "[T]he only thing you’ll generate is a demand for safe assets — and by that I mean...they’re going to be buying a bunch of safes so people can put their money in their safes rather than in the bank."

But nobody really seems to have a good handle on what the new, negative lower bound might be. So how much would it actually cost, I wondered, to store $10,000 in currency for a year?

This seems to me a decent, and admittedly entertaining, way of getting a rough estimate of a lower bound. I picked $10,000 because it's about twice the average balance of a savings account in the U.S., giving me a conservative estimate of the average percentage cost.

A safe deposit box at a bank seems to cost around $100 a year after insurance. Then the average cost of storing currency is about 1 percent annually -- maybe a bit more if you buy a safe.

Yet, rather obviously, having $10,000 in a deposit box is not the same thing as having $10,000 in a bank account. You can spend from your bank account using a credit card, or you can go to an ATM and withdraw cash. You can't do the same with a safety deposit box.

How much is that convenience worth? It seems like a hard question, but we have a decent proxy for that: credit card fees, counting both those to merchants and to cardholders. That's because the credit-card company is making exactly the same calculus as we are trying to make -- how much can we charge before we make people indifferent between currency and credit cards? The data here suggest a conservative estimate is 2 percent annually.

So my rough guess is that the average depositor is probably better off keeping their money at a bank up to a nominal interest rate of -3 percent annually. (This is also what other people said, in an extremely informal poll, would be the most they would accept.) But, from an economic perspective, what we really care about is the marginal depositor -- that is, who has the lowest cost of currency storage?

And here, I am at a loss. Are there are efficiencies of scale in currency storage? What does the marginal cost curve for currency storage look like?

Would banks, in response to persistently negative nominal interest rates on deposits, increase the amount they keep in currency in vaults? Or would investors start bidding up the price of any asset that can function as a store of value and try to find ways to make their holdings function more like liquid deposits? Do companies start doing weird things with inventories and working capital?'


Further reading:

Paul Krugman and David Keohane have both weighed in. Krugman argues that, since the marginal holder of currency is only doing it as a store of value, the convenience doesn't matter to finding the true lower bound. Keohane reviews some useful ECB numbers and discussion from Barclays -- we're all ending up in the same range of numbers.

Sunday, March 1, 2015

Assorted Links

1. Could air pollution be the first environmental issue to pierce the "development first, democracy later" agenda of China? Here's some solid new evidence that air pollution hurts infants and holds them back for the rest of their lives. Via Brad Plumer, it's also an issue in India.

2. "I find that affirmative action sharply increases the black share of employees, with the share continuing to increase over time...Strikingly, the black share continues to grow even after an establishment is deregulated."

3. Real, lasting reductions in the incarcerated population will take much more robust programs that ease the transition back to into the labor market.

4. Is "housing lock" real? Yes: "A decline in home equity is associated with large and statistically significant reductions in household mobility. A rise in the LTV ratio from 90 to 115% is associated with a 30% decline in household mobility." No: Henry Farber and Rob Valletta.

5. How, in 1967, Reagan changed the purpose of America's public universities. Also, check out this older piece by Aaron Bady and Mike Konczal about how that historical moment started the shift towards ever less state funding.

From Japan to Switzerland

How do big shocks to the exchange rate affect stock prices? We can look at two recent examples: the devaluation of the Japanese yen under the Kuroda regime shift and Jordan's de-pegging of the Swiss franc.

As the Japanese yen has dropped, the Nikkei has soared. That's not just a story of two broadly matching trends, either. The relationship holds strongly on a day-to-day basis, suggesting that whatever's driving the yen down is also driving the Nikkei up.

I think the first thing to ask with Japan is: Has it always been this way? To retell the conventional story, Japan has struggled with persistent deflationary pressures and a rising yen. Maybe it's the case, then, that whenever markets saw the yen weakening, they also became excited about the prospects of Japanese companies, particularly exporters?

Or we could tell a similar story that says this really isn't about exporters gaining from a weak yen to undercut competitors in foreign markets and pocket some profits. Pretend, for a moment, that all Japanese companies did was export and price goods in the local (i.e. export-destination) currency, and they didn't increase production or profit margins or gain market share. Then if the yen depreciated, and input prices didn't change, we should expect profits to rise passively one-for-one in yen, but stay flat in other currencies. What's merely going on is that when the Japanese exporters repatriate foreign profits, they will do so into a devalued currency.

But wait, there's more. The Bank of Japan's regime change has set off a wave of capital flows, both into and out of Japan as well as within Japan and among Japanese asset classes. For example, Japanese retirees sitting on portfolios of government bonds have seen yields come crashing down, and they have responded with some combination of pouring into Japanese equities and getting their money out of yen-denominated assets.

The first two stories seem to require the relationship between the yen and the Nikkei to be an "always-and-everywhere" thing. That is, it's not clear why a cheap yen would only sometimes help exporters, and not other times. Similarly, the passive repatriation story should always hold. But the third story is really about a third cause, a single event, behind these two patterns.

So let's take this to the data.

It turns out that the link began in 2007 -- a time when things were going the other way, that is, the Nikkei was falling on the days the yen was appreciating. There doesn't ever seem to be much of a sustained pattern before then, but maybe somebody who knows Japan better than I do can make something intelligent out of the squiggles of the 1980s and 1990s.

I think this puts a lot of doubt into the first and second stories, which is surprising to me, because both make a lot of sense! It's quite believable the Japanese yen is really just the repatriation currency for countries that do business elsewhere or that Japanese exporters benefit from a weak yen, although admittedly input prices is a bit of a problem for that story.

We should also take a look at the value of the coefficient: It's around, maybe a bit less than, one. That might actually work with the repatriation story. But hold on a second. If you look at the cumulative change in the yen and in the Nikkei, what you get is a 2-for-1 relationship. That is, for every one percent decline in the value of the yen against the U.S. dollar, Japanese equities rise 2 percent. And that would require more than the repatriation effect.

So my read of the Japan situation is that the relationship between the yen and the Nikkei is a historically contingent one that has emerged from two big waves of capital flows, the 2008 risk-off amid the financial crisis and then the 2012 Kuroda shift. The other stories don't fit the data.

Now onto Switzerland. On January 15, the Swiss central bank suddenly announced it would stop defending a currency floor that kept the Swiss franc from appreciating beyond 1.20 franc to the euro. The basic reason, the data suggest, is that it did not want to keep expanding its balance sheet. That day the Swiss franc appreciated nearly 20 percent against the euro.

What happened to stocks? As this chart from Markus Brunnermeier shows, they fell a bit less than the currency rose:

Brunnermeier focuses here on the Swiss financial sector, which handled the Swiss franc's sudden rise about as well as the broader economy. We might also break out companies in the index that are particularly focused on foreign markets, such as Swatch, Credit Suisse, Nestlé, Roche, and Novartis. They also seem to have dropped somewhat less than the rise in the Swiss franc. In fact, if you look at a currency-hedged index of Swiss equities, that rose sharply on the day of the de-pegging.

The advantage of Switzerland as a case study is that the appreciation was unanticipated, whereas in Japan, the whole point was to shout it from the rooftops. This shuts off the capital-flows story and leaves us with the two export-oriented ones. It doesn't seem likely the Swiss exporters were very much disadvantaged -- despite their complaints -- if Swiss equities rose when converted to other, more stable currencies. What it fits, rather, is the passive repatriation story: Swiss exporters' profits fall in Swiss franc when the franc rises because every dollar of foreign profits is worth less in Swiss franc than it was before. Another reason why it might not be surprising that Switzerland seems to fit that story: Switzerland is a vastly more export-heavy economy than Japan. Its exports-to-GDP ratio was 72 percent in 2013, as compared to Japan, which stood at 16.2 percent of GDP in 2013.

While Japan and Switzerland both fit the same pattern -- currency up, stocks down; currency down, stocks up -- the patterns emerged for distinct reasons. For Japan, it was the coordination of capital flows, whereas for Switzerland, the explanation seems to be that exporters would have to repatriate profits at a punishingly high exchange rate.

Saturday, February 28, 2015

Assorted Links

This blog is back. Now that I am in my junior spring, and life is a bit more under control, posting will begin again. I've missed this enormously. The balance of topics may shift a bit, but I'll let that emerge organically. A substantive post later today, but for now, some links:

1. In Scotland and Northern Island, private banks issue banknotes. (News to me.)

2. "I find that private securitization substantially increases foreclosure probability and decreases modification probability for delinquent loans."

3. Economists think a Greek default would be a big gamble with a highly uncertain payoff.

4. Lots of good new data on FRED. The elasticity of sub-minimum wage employment with respect to the federal minimum is much higher than I would have guessed.

5. The theologian John Hull on blindness, a short film from his tape recordings. Haunting.

6. YouTube channel putting together weekly education videos on World War I, via Reddit.

7. The next shoe to drop in the oil-price decline is panic among the petroleum-engineering departments of universities. See here, here, and here. Useful counter-evidence to the conventional wisdom that a dynamic global economy (or insert buzzword) increases the need for vocational, specialist, or technical education. It does the opposite.