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Paychecks or Promises? Lessons from the Death Spiral of Detroit

August 12, 2014 Comments off

Paychecks or Promises? Lessons from the Death Spiral of Detroit
Source: Federal Reserve Bank of Minneapolis

Pay-with-promises compensation plans accumulate liability for future employee benefits, such as retiree health insurance. A simple economic model demonstrates that such plans can exacerbate fiscal crises faced by cities that experience external economic shocks, such as the departure of a major employer. City leaders often raise taxes and/or reduce public services to pay off legacy employee debts, and such steps encourage residents to move out, reducing the tax base and raising fiscal stress. Pay-as-you-go compensation plans are more prudent; they settle liabilities to employees paycheck by paycheck.

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Growing Risk in the Insurance Sector

April 3, 2014 Comments off

Growing Risk in the Insurance Sector
Source: Federal Reserve Bank of Minneapolis

The financial crisis of 2008 exposed important vulnerabilities in the banking sector. In its aftermath, considerable academic effort has been devoted to better understanding banking risks, and policymakers around the world are developing new regulations to contain those risks.

Our recent and ongoing work shows that there are also important risks in the insurance sector. Although these risks have been growing rapidly over the past 15 years, they have received relatively little attention from academics and regulators. If unaddressed, these risks could cause severe problems. Insurance is a large share of the financial sector. For example, U.S. life insurance liabilities amounted to $4.1 trillion in 2012, compared to $7 trillion in U.S. savings deposits. Moreover, as the largest institutional investors in the corporate bond market, insurance companies serve an important role in real investment and economic activity.

We begin this note by describing the growing risks and highlight some early symptoms, based on evidence during the financial crisis. We follow with a discussion of possible economic consequences of trouble in the insurance sector. Finally, we highlight points of attention for policymakers and discuss recent developments in global insurance markets.

What Will Happen When Foreigners Stop Lending to the United States?

September 11, 2013 Comments off

What Will Happen When Foreigners Stop Lending to the United States?
Source: Federal Reserve Bank of Minneapolis

Since the early 1990s, the United States has borrowed heavily from its trading partners. This paper presents an analysis of the impact of an end to this borrowing, an end that could occur suddenly or gradually.

Modeling U.S. borrowing as the result of what Bernanke (2005) calls a global saving glut—where foreigners sell goods and services to the United States but prefer purchasing U.S. assets to purchasing U.S. goods and services—we capture four key features of the United States and its position in the world economy over 1992–2012. In the model, as in the data: (1) the U.S. trade deficit first increases, then decreases; (2) the U.S. real exchange rate first appreciates, then depreciates; (3) the U.S. trade deficit is driven by a deficit in goods trade, with a steady U.S. surplus in service trade; and (4) the fraction of U.S labor dedicated to producing goods—agriculture, mining and manufacturing—falls throughout the period.

Using this model, we analyze two possible ends to the saving glut: an orderly, gradual rebalancing and a disorderly, sudden stop in foreign lending as occurred in Mexico in 1995–96. We find that a sudden stop would be very disruptive for the U.S. economy in the short term, particularly for the construction industry.

In the long term, however, a sudden stop would have a surprisingly small impact. As the U.S. trade deficit becomes a surplus, gradually or suddenly, employment in goods production will not return to its level in the early 1990s because much of this surplus will be trade in services and because much of the decline in employment in goods production has been, and will be, due to faster productivity growth in goods than in services.

The Case of the Disappearing Large-Employer Manufacturing Plants: Not Much of a Mystery After All

July 14, 2011 Comments off

The Case of the Disappearing Large-Employer Manufacturing Plants: Not Much of a Mystery After All
Source: Federal Reserve Bank of Minneapolis

This paper seeks to contribute to policy discussion over recent declines in U.S. manufacturing through close investigation of employment trends in U.S. manufacturing plants with 1,000 or more workers, “large-employer plants.” These plants are disappearing at a rate much greater than the decline in manufacturing as a whole. To determine what is happening to these plants, the paper links the 1997 and 2007 published Census Bureau tabulations of the locations of manufacturing plants. This makes it possible to distinguish between plants that are no longer large employers because they have downsized to a smaller employment level and plants that have closed outright.

The author concludes that the dramatic disappearance of large employers is neither mysterious nor surprising. Most of the missing large employers from 1997 are still open, only with fewer employees. The plants that have closed have tended to rely on large quantities of unskilled labor, making them vulnerable to strong import competition from China and other nations, where unskilled labor is less expensive.

The analysis begins with trends in all of U.S. manufacturing and narrows successively. The initial narrowing focuses on a specific geographic area, the “Piedmont region” of the southeastern United States, which has specialized in manufacturing industries that use unskilled labor intensively. Scrutiny then narrows further within the Piedmont to industries heavily impacted by imports from China, designated here as “China surge industries.” The analysis ends by contrasting how two large-employer plants making furniture in the Midwest have managed to survive, while the furniture industry in the Piedmont region has collapsed.

Liquidity Crises

May 19, 2011 Comments off

Liquidity Crises
Source: Federal Reserve Bank of Minneapolis

Liquidity crises that induce or exacerbate deep recessions, as in 1930 or 2008, are situations in which individuals and firms want to build holdings of liquid assets. Heightened risk, or a perception of it, substantially increases demand for these assets. This reduces the supply available for normal transactions, leading to production and employment declines.

What happened in September 2008 was a kind of bank run. Creditors lost confidence in the ability of investment banks to redeem short-term loans, leading to a precipitous decline in lending in the repurchase agreements (repo) market. Massive lending by the Fed resolved the financial crisis, but not before reductions in business and household spending had led to the worst U.S. recession since the 1930s.

In this essay, we first sketch theoretical ideas that bear on the sources of liquidity crises: bank runs, sunspots and contagion effects, and the moral hazard problem created by deposit insurance. We then describe the repo market, and argue that these theoretical concepts are useful for understanding that market as well.

We conclude with several lessons for regulatory reform and for the role of Federal Reserve policy in coping with future liquidity crises:

  • Bank regulation can reduce the likelihood of liquidity crises, but cannot eliminate them entirely.
  • During a liquidity crisis, the Fed should act as a lender of last resort.
  • The Fed should announce its policy for liquidity crises, explaining how and under what circumstances it will come into play.
  • Deposit insurance is part of the answer, but has a limited role.
  • The Fed’s lending in a crisis should be targeted toward preserving market liquidity, not particular institutions.

A sharp drop in interstate migration? Not really

April 25, 2011 Comments off

A sharp drop in interstate migration? Not really
Source: Federal Reserve Bank of Minneapolis

Many policymakers have expressed concern that unemployment remains high, in part, because the once highly mobile American worker has suddenly become unable or unwilling to move across the country for a job. This paper shows that this concern is unnecessary: Contrary to popular belief, interstate migration did not fall substantially during the Great Recession; in fact, interstate migration has probably been overestimated in the past.

The misperception of a sharp drop in migration is due to a statistical artifact. In 2006, the Census Bureau changed the methods for handling data for people who do not answer migration questions in the Bureau’s Current Population Survey. We find that this change in data-handling procedures—not any change in actual migration patterns—explains nearly half of the reported decrease in interstate migration between 2000 and 2010. Many factors are undoubtedly to blame for high unemployment in the United States, but a sharp drop in migration is not among them.

Accounting for the Great Recession

March 7, 2011 Comments off

Accounting for the Great Recession
Source: Federal Reserve Bank of Minneapolis

The 2007-09 U.S. recession was much different from other U.S. recessions since World War II. It was also unlike recent recessions in other advanced economies. Qualitatively, it closely resembles the Great Depression, particularly in its large impact on labor markets. This policy paper describes defining characteristics of the recent recession, analyzes distortions in economic relationships during it and other recessions, and examines two hypotheses for the Great Recession’s severity and length in the United States.

Empirical examination indicates that the decline in economic output and income in the recent U.S. recession (unlike the others mentioned) was due exclusively to severe distortion in labor markets, a key commonality with the Great Depression.

Analysis of potential distortions in economic relationships reveals virtually no deviation in productivity and very little distortion in capital investment during the 2007-09 U.S. recession. By contrast, U.S. labor markets exhibited extremely large distortion; labor income was essentially being taxed at nearly 13 percent.

Two hypotheses for the Great Recession—financial markets dysfunction and poor government policy—are discussed in the context of these diagnostic findings. The paper ultimately concludes that serious questions remain regarding the financial explanation. The policy explanation is more promising, but requires significant further research.

+ Full Paper (PDF)

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