Why Recessions are Bad...for Your Happiness

In my previous posting I discussed some papers that showed recessions to be good on balance for your health. However, a paper by Rafael Di Tella, Robert J. MacCulloch and Andrew J. Oswald titled "The Macroeconomics of Happiness" finds that there are large psychological costs to recessions. Since emotional health affects physical health, it stands to reason that these findings indicate recessions are bad for health.

The Macroeconomics of Happiness (ungated version)

We show that macroeconomic movements have strong effects on the happiness of nations. First, we find that there are clear microeconomic patterns in the psychological well-being levels of a quarter of a million randomly sampled Europeans and Americans from the 1970s to the 1990s. Happiness equations are monotonically increasing in income, and have similar structure in different countries. Second, movements in reported well-being are correlated with changes in macroeconomic variables such as gross domestic product. This holds true after controlling for the personal characteristics of respondents, country fixed effects, year dummies, and country-specific time trends. Third, the paper establishes that recessions create psychic losses that extend beyond the fall in GDP and rise in the number of people unemployed. These losses are large.

Why Recessions are Good...for Your Health

Yes, there is a silver lining to the recession of 2008: your health should improve. At least that is the finding from a number of empirical studies. These studies indicate recessions help induce behavioral changes that are conducive to healthier lifestyles. Christopher Ruhm, a seminal figure in this literature, explains how this process could work: "Individuals might adopt healthier lifestyles when the economy weakens because increases in non-market time make it less costly to undertake health-producing activities such as exercise or the consumption of a healthy diet. Reductions in incomes and employment related stress could also decrease the frequency of 'self-medication' by smoking and drinking." (source) These results are contrary to what I expected, though consistent with my own research that shows some individuals get more religious during economic downturns. Advocates for recession's 'cleansing effects', then, may find this research to bolster their case.

Here are links and abstracts to some of these studies. First up, Christopher Ruhm's paper "Healthy Living In Hard Times":

Using microdata for adults from 1987 to 2000 years of the Behavioral Risk Factor Surveillance System (BRFSS), I show that smoking and excess weight decline during temporary economic downturns while leisure-time physical activity rises. The drop in tobacco use occurs disproportionately among heavy smokers, the fall in body weight among the severely obese and the increase in exercise among those who were completely inactive. Declining work hours may provide one reason why behaviors become healthier, possibly by increasing the non-market time available for lifestyle investments. Conversely, there is little evidence of an important role for income reductions. The overall conclusion is that changes in behaviors supply one mechanism for the procyclical variation in mortality and morbidity observed in recent research.

Next, Ruhm's paper "A Healthy Economy Can Break Your Heart":

Panel data econometric methods are used to investigate how the risk of death from coronary heart disease (CHD) varies with macroeconomic conditions after controlling for demographic factors, fixed state characteristics, general time effects and state-specific time trends. The primary analysis covers 1979-1998, with a supplemental investigation of medical procedures during 1994-2003. A one percentage point reduction in unemployment is predicted to raise CHD mortality by 0.75 percent, corresponding to almost 3,900 additional fatalities. The increase in relative risk is similar across age groups implying that senior citizens, who have the highest fatality rates, account for most of the extra deaths.

And another Ruhm paper coauthored with Ulf-G. Gerdtham titled "Deaths Rise in Good Economic Times: Evidence from the OECD":

This study uses aggregate data for 23 OECD countries over the 1960-1997 period to examine the relationship between macroeconomic conditions and deaths. The main finding is that total mortality and deaths from several common causes rise when labor markets strengthen. For instance, controlling for year effects, location fixed effects, country-specific time trends and demographic characteristics, a one percentage-point decrease in the national unemployment rateis associated with growth of 0.4 percent in total mortality and the following increases in causespecificmortality: 0.4 percent for cardiovascular disease, 1.1 percent for influenza/pneumonia,1.8 percent for liver disease, 2.1 percent for motor vehicle deaths, and 0.8 percent for otheraccidents.

Finally, José A Tapia Granados paper "Increasing mortality during the expansionsof the US economy, 1900–1996":

... Statistically and demographically significant results show that the decline of total mortality and mortality for different groups, ages and causes accelerated during recessions and was reduced or even reversed during periods of economic expansion—with the exception of suicides which increase during recessions. In recent decades these effects are stronger for women and non-whites.

Bernanke to Reinhart:"Et tu, Brute?"

Vincent Reinhart, former director of the Division of Monetary Affairs at the Federal Reserve and coauthor with Ben Bernanke on several papers, had an article in the Wall Street Journal titled "Our Overextended Fed." In this piece, Reinhart takes to task his former colleagues at the Fed for setting moral hazard-creating precedents as well sending panic signals to investors. His frank rebuke of the Fed's actions are surprising for a former high-ranking Fed official.

Our Overextended Fed

In the past few weeks, the Federal Reserve has fundamentally redefined the role of a central bank in a market economy.

Almost one-half of our nation's central bank balance sheet -- more than $400 billion -- is exposed to credit risk through new lending facilities. It has also entered an open-ended commitment to use its discount window to back stop major securities firms. Those efforts will influence the depth of the recession that the U.S. economy has likely already entered, and will leave a durable imprint on the financial landscape for many years to come.

[...]

The desire on the part of policy makers to draw a line defending the existing structure of the financial system is understandable. But one can wonder if the trenches the Federal Reserve has dug are this generation's Maginot Line -- ineffective in defense and costly in the long run.

The Federal Reserve put its balance sheet in harm's way to give assurance to Bear Stearns's creditors and extended that protection to the other primary dealers. In doing so, the Board of Governors of the Federal Reserve had to determine unanimously (since they only had five members at the time) that these were "unusual and exigent" circumstance and that failure to lend to Bear would have adverse consequences for the U.S. economy. The signaling aspect of that decision cannot help but have adverse consequences for investors' willingness to take on risk.

Moreover, the implicit declaration that a midsize investment bank was systematically important puts any firm at least as big as Bear in the cross-hairs of speculators. In coming days, how can the Federal Reserve turn away another like-sized entity, whether primary dealer or not, that is suddenly in the marketplace's disfavor for having used leverage to borrow at short-term maturities to fund longer-term obligations?

In such circumstances, the Federal Reserve's $900 billion balance sheet will not look that big. And the Federal Reserve will have ceded control of its balance sheet to the needs of private-sector entities.

More seriously, the Federal Reserve's action can only be viewed as rewarding bad behavior. Remember that Bear opened this financial crisis when it revealed problems at its sponsored hedge funds last June. That it did not spend the next nine months resolving its problematic positions and getting sufficient capital did not prevent it from getting a "get out of jail free" card from the Federal Reserve.

[...]

Read the Rest.

Looking for an Updated Monetary Textbook

I am slated to teach two sections of undergraduate Money & Banking in the fall semester and am already being accosted by the book reps. Talking with the book reps started me thinking--are there any monetary textbooks out there that will make sense in the fall? Given the ongoing meltdown in financial markets and the many central banking innovations that have taken place in response (e.g. TAF, TSLF), I suspect many, if not all, monetary texts will have gaping holes in them. So I was pleased to read Jim Hamilton was thinking along similar lines when wrote the following:

If you took a college course on monetary policy more than six months ago, what you learned has already been rendered out of date by the big changes Bernanke has implemented in how monetary policy can be used.

So are there any monetary textbooks out there that will reflect the new realities of central banking? Fortunately, we live in a world of the internet and economic blogging where all you need to know about this crisis is just a click away. Still, it would be nice to have a textbook that is current for students.

Update

I should have stated more explicitly that the link above is to Francisco M. Torralba's nice summary of the Fed's new tools. Also, see Vincent Reinhart's article, "The Fed's New Alphabet Soup."

What Many of the Great Depression Comparisons Miss

There seems to be many observers comparing the current economic crisis to that of the Great Depression. Amity Shales does a good job reviewing and correcting some of the comparisons. Following her lead, I want to briefly comment on Paul Krugman's latest NY Times piece titled "Partying Like It's 1929." Krugman makes the case that we have forgotten an important lesson learned from this period: regulating the financial system. One of the main contributors to the Great Depression was the massive collapse of the banking system--about 9000 banks fell. Krugman believes this development turned what would have been a normal recession into the Great Depression. While some economists would debate whether this was the most important factor, no one disputes that it turned a bad situation into something worse. Here is Krugman:

What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931.

This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure.

As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way.

Krugman fails to mention some important details about the banking system in the 1920s and 1930s that undermines his thesis that it was "unregulated, unsupervised financial markets" that caused the banking crisis of the 1930s. First, there is a huge literature that shows a key reason for the massive banking collapse was the unit banking laws of the time--laws preventing banks from having more than one branch. The absence of interstate, and sometimes intrastate, branch banking meant bank assets were poorly diversified. For example, a bank in Kansas would hold loans mostly from farmers, making it susceptible to swings in the agricultural market. Now imagine if that same Kansas bank had branches throughout the nation. It's balance sheet would now include loans to sectors of the economy other than just farming. Simply put, its balance sheet would more diversified and better insulated from negative economic shocks.

A second advantage of branch banking is that even if a non-rational, panic-driven bank run starts it can be nipped in the bud at the onset. Imagine now the panic erupts at the bank in Kansas. People rush to bank and a big line forms outside. Instead of running out of reserves, the bank in Kansas can now pull in reserves from its branch bank in the next county. This will stem the panic and prevent it from becoming systemic.

Now, are these ideas merely theoretical? No; one needs to look no further than Canada during the Great Depression. Canada, unlike the United States, had nationwide branch banking. Guess how many banks shut down in Canada during the Great Depression? Zero. Yes, you read that correctly, zero banks shut down in Canada while around 9000 shut down in the United States. Oh, did I mention that Canada did not have a central bank during the worst part of the Great Depression? And yes, the real economy was hit just as hard in Canada as it was in the United States.

A good survey of the branch banking literature is found in Charles Calomiris' book, U.S. Bank Deregulation in Historical Perspective. It is also worth noting that some researchers such as David Wheelock also point out that experiments by state governments with deposit insurance in the 1920s also contributed to the problem. His research finds that deposit insurance "caused more entry and encouraged greater risk-taking than would have otherwise occurred and, hence, the banking systems of states with insurance might have been more vulnerable to a decline in economic activity." (source here)

So Krugman's claim that it was the "unregulated, unsupervised financial markets" that caused the bank runs misses some important details. If I were writing Krugman's column I would say it was the "poorly designed banking system aided by a poorly run Federal Reserve" that contributed to the collapse of the banking system.

So if this is the season for making comparisons to the Great Depression, what is the relevant comparison for financial markets today? Are the financial market as poorly designed today as they were back then?

What Paul Krugman Thinks of Monetary Policy These Days

Paul Krugman has begun a liquidity trap watch.

Tyler Cowen on Deflation

While grading papers yesterday, I listened to Tyler Cowen's EconTalk on monetary policy with Russ Roberts. Listening to Tyler's calm, soothing voice as he discussed all things monetary made the frustrations of grading all the more bearable. The discussion is definitely worth your time.

Amidst the Cowen-induced calm, however, I did have a momentary lapse into the land of angst when the topic of deflation was brought up. Roberts asked Cowen what would happened if the monetary base were frozen in a growing economy. Cowen correctly replied that there would emerge deflationary pressures. He then proceeded to say, though, that such a development would be a destabilizing outcome since people are not capable of handling a world of falling prices. Owing to "human irrationality", Cowen claimed worker morale would suffer if laborers got a 3% nominal wage cut even if the price level fell 4% in an expanding economy. Moreover, maintaining inflationary expectations among workers provides an "easy way to trick people into a wage cut" if needed.

Wow--is this really Tyler Cowen or his evil twin Tyrone Cowen? I certainly did not expect this response from Tyler. Let me begin my reply to whichever Cowen it may be by stating up front I do not advocate a freezing of the monetary base (although something like that happened after the U.S. Civil War). I am, though, open to a monetary policy rule that allows for productivity changes to be more fully reflected in the price level--George Selgin's Productivity Norm rule comes to mind--because doing so may actually improve macroeconomic stability (see here). Such an approach to monetary policy would also imply mild deflation at times, so Cowen's critiques still apply and must be examined.

So, Cowen believes people are subject to a form of money illusion that only allows them to be fully functional when prices are rising. In short, people are too dumb to distinguish between nominal and real values. This understanding is surprising for someone who champions a more libertarian view of the world, one where individuals are capable of making choices--such a distinguishing between nominal and real values--that improve their welfare. Empirical evidence suggests Cowen should take more seriously his libertarian instincts on this issue. Michael Bordo and Andrew Filardo in their article "Deflation in Historical Perspective" review the literature on this topic and conclude

... that such notions of downward wage inflexibility that were formed during the Great Inflation may in fact be regime-dependent. It is possible that once a low inflation or moderate deflation environment were to become more familiar, the past psychological aversion to downward nominal, rather than real, movements would become less of a constraint.

Even stronger evidence for regime-dependent framing of expectations comes from Christopher Hanes and John A. James in their AER article, "Wage Adjustment under Low Inflation: Evidence from U.S. History" From their conclusion:

We have looked for evidence of downward nominal wage rigidity in the nineteenth-century United States, using data that allow clear comparisons between historical and modem patterns. We find no evidence of downward nominal wage rigidity in the historical data, especially when they include the various monetary regimes of the 1860's and 1870's. One interpretation consistent with our results would be that the modern wage floor reflects employers' fear of damaging employee "morale" by violating social norms and concepts of fairness (as described by Bewley, 1999) rather than a fundamental preference on the part of workers. Unlike fundamental preferences, social norms can change with the economic environment. Under monetary regimes delivering very low trend inflation, such as the postbellurn deflation, a norm that enforced downward nominal wage rigidity could become costly for individual employers and employees, as well as for society as a whole… It seems safe to conclude… that U.S. historical experience fails to support the proposition that downward nominal wage rigidity is a fundamental feature of employment that prevails under any circumstances.

Cowen's view, then, of downward nominal wage rigidity is more representative of the inflationary times in which we live than a universal truth.

As I mentioned above, there are also reasons related to macroeconomic stability that should make Cowen more open to deflation, at least the benign form. That is why I like George Selgin's Productivity Norm rule. (In case you missed it, here are my postings on the relationship between macroeconomic stability and benign deflation.) From what I can tell, Cowen's colleague Bryan Caplan takes this latter point more seriously. Sometime they should get together and discuss George Selgin's "Less than Zero".

Update: G. Selgin makes an excellent point in the comments section--there is no need for a downward wage adjustment under the productivity norm. The decline in the price level will guarantee a rise in the real wage. Thus, the issue of whether wages are downwardly mobile is really inconsequential with productivity norm.