The 'Big Push' and Economic Development in the American South

One of the great stories from 20th century U.S. economic history is the great economic rebound of the American South. From the close of the Civil War up through World War II, this region’s economy had been relatively undeveloped and isolated from the rest of the country. This eighty-year period of economic backwardness in the South stood in stark contrast to the economic gains elsewhere in the country that made the United States the leading industrial power of the world by the early 20th century. Something radically changed, though, in the 1930s and 1940s that broke the South free from its poverty trap. From this period on, the South began modernizing and by 1980 it had converged with the rest of the U.S. economy. But why the sudden break in the 1930-1940 period? A new paper by Fred Bateman, Jaime Ros, and Jason E. Taylor provides a fascinating answer: the economic rebound of American South was the result of a 'Big Push' from large public capital investments during the Great Depression and World War II.

A novel contribution of this paper is that it appears to provide a real-world example of the 'Big Push' theory. Never heard of the 'Big Push' theory? Well, here is how the authors describe it:

According to the “big push” theory of economic development, publicly coordinated investment can break the underdevelopment trap by helping economies overcome deficiencies in private incentives that prevent firms from adopting modern production techniques and achieving scale economies. These scale economies, in turn, create demand spillovers, increase market size, and theoretically generate a self-sustaining growth path that allows the economy to move to a Pareto preferred Nash equilibrium where it is a mutual best response for economic actors to choose large-scale industrialization over agriculture and small-scale production. The big push literature, originated by Rosenstein-Rodan [1943, 1961], was initially motivated by the postwar reconstruction of Eastern Europe. The theory subsequently appeared to have had limited empirical application... [S]cholars have found few real-world examples of such an infusion of investment helping to “push” an economy to high-level industrialization equilibrium.

Until this paper, that is. The authors continue:

We argue here that the “Great Rebound” of the American South, which followed large public capital investments during the Great Depression and World War II, is one such application. Although 1930s New Deal programs are typically presented in the context of their attempt to bring relief and recovery to the U.S. economy through demand-stimulating public expenditures, the long-term economic effects of these and subsequent wartime expenditures were profound for the South. Specifically, and consistent with big push theoretical literature, the infusion of public capital—roads, schools, waterworks, power plants, dams, airfields, and hospitals, among other infrastructural improvements—fundamentally reshaped the Southern economy, expanded markets, generated significant external economies, increased rates of return to large scale manufacturing, and encouraged a subsequent investment stream. These improvements helped create the conditions that allowed the region to break free from its low-income, low-productivity trap and embark on its rapid postwar industrialization.

This paper deals with the break from the South's poverty trap. The sustained nature of the South's postwar economic recovery has been covered by other studies: Connolly (2004) looks to improved human capital formation, Cobb (1982) points to industrial policy, Beasley, Persson, and Sturm (2005) finger increased political competition, and Glaeser and Tobio (2008) discuss the merits of the climate or Sunbelt effect. (I will also note I have seen somewhere the advent of air conditioning did wonders for development in the South).

In short, this paper tells an interesting and under reported story of 20th century U.S. economic history. In so doing, it also provides what appears to be a good example of the 'Big Push'. Read the rest of the paper here.

That's Why I Have Been Making So Many Trips to the Grocery Store

Rich Karlgaard clues us in to the secrets of survival for firms producing consumer goods in a stagflationary environment:

At a campground breakfast last month I grabbed a little box of Raisin Bran cereal. I opened the box and popped the waxed paper, which let out a mighty whoosh of air I felt in the eyeballs. I tore the wax paper and discovered the source of the whoosh: The box was mostly filled with air. I imagined some bran flakes hiding in the bottom. To test this theory, I poured the contents into a bowl. Indeed, there was some Raisin Bran in there--about 20 flakes. I fetched two more boxes and emptied the flakes and raisins into the bowl. It took three boxes to make a halfway decent bowl of cereal.

[...]

Robbery at the cereal box indicates that stagflation is America's real problem now. Cereal vendors are afraid to raise prices. They know that American wages have risen little of late, and the small gains have been eroded by gas prices. So cereal vendors play a game with consumers: charge more by giving less.

One can't be angry at the cereal vendors, by the way. Their costs for goods and distribution have skyrocketed. They have no choice but to raise prices or serve up fewer flakes. Or go out of business...

Steve Forbes has pointed out that while the pastries he buys each morning at Starbucks cost the same, they've shrunk in size. Containers of Shedd's Spread Country Crock used to consist of 48 ounces of margarine, but buyers now pay the same price to get 45 ounces. Frequent RealClearMarkets contributor Doug Johnson notes that the cost of a package of diapers for his children hasn't gone up, but today there are four less diapers in each package.

Fueling Inflation, Maintaining Imbalances

Mark Gertler recently asserted the United States should "not act rashly over inflation" fears. He argued that the recent jump in U.S. inflation is the result of relative price changes in food, energy, and other commodities and not the consequence of policy-induced aggregate demand pressures. Mark Thoma concurs and notes that since relative price changes provide "important signals to the economy about where resources are needed most and about the opportunity costs of employing them...we don't want to mute those signals..." In short, negative supply shocks are the source of the recent inflationary pressures and are not the type of price shocks that should be addressed by policy (unless they add momentum to a growing inflationary spiral--something the two Marks do not see happening).

This interpretation, however, begs the question of why these commodity are soaring in the first place? Could it be that in addition to the usual suspects--increased Asian demand, biofuel distortions, speculators--that loose U.S. monetary policy is playing a part? Given the monetary hegemon role played by the Federal Reserve--its monetary policy gets exported to all those countries pegged to the dollar--it seems reasonable to conclude that some of the increase in commodity prices are more than relative price changes; they are in part the result of policy-induced aggregated demand pressures. That is what I was thinking, anyhow, when reading Gertler's article. I was not alone in my thinking. Ken Rogoff makes a similar case in the FT:

As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

[...]

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation (expressed mainly through a temporary acceleration in renminbi appreciation), has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach.

Dollar bloc countries have slavishly mimicked expansionary US monetary policy, even in regions such as the Middle East, where rapid growth is putting huge upward pressure on inflation. Of the major regions, only Europe, led by the European Central Bank, has resisted joining the stimulus party so far. But even the ECB is coming under increasing domestic and international political pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus, albeit at the expense of loosening inflation expectations and possibly paying a steep price to re-anchor them later on. But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Rogoff goes on to address Gertler's claim that the Fed should more concerned about the financial crisis than the inflationary pressures:

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? It is hard to see the argument in emerging markets where inflation is raging, but even in epicentre countries it is becoming increasingly dubious. Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to have several years of elevated inflation to help bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on.

Another consequence of this pump-priming aggregate demand was recently mentioned by Brad Sester:

The [U.S.] policy response to the subprime crisis has avoided the sharp adjustment that many feared. But it also meant that many of the underlying imbalances haven’t really corrected. The composition of the US current account deficit has changed – the oil deficit is bigger, the non-oil deficit is smaller; the fiscal deficit is bigger and aggregate deficit of households is smaller - but the aggregate deficit remains large. And the rest of the world’s imbalances haven’t corrected either. China’s economy remains unbalanced. The oil surplus has gotten bigger.

Hence it is possible to argue — see Yves Smith — that risks are still increasing.

So in addition to potentially unanchoring inflationary expectations, U.S. policy--with help from foreign governments--has put off for another day the inevitable correction of economic imbalances.

Not Following the Pattern

Brad Sester had an interesting post that looks at how U.S. economic imbalances have been affected by the subprime crisis. First, he notes what typically happens to countries running huge current account deficits like the United States when hit with a economic crisis like the subprime one:

Emerging market financial crises in the 1990s followed a fairly consistent pattern.

The country lost access to external financing.

The sector of the economy that had a large need for financing – firms in Asia, the government elsewhere – had to dramatically reduce its need for financing. Asian investment collapsed. Argentina swung from a fiscal deficit to a fiscal surplus (helped along by its default on its external debt). Turkey began to run large primary surpluses.

Financial balance sheets shrank; credit dried up.

The country’s currency fell sharply. And its current account swung into balance, if not a surplus.

That process was incredibly painful. Falls in GDP of 5% or more were not unknown. It also meant that after a year or so, most emerging markets had reached bottom. Their economies had adjusted, as had their currencies.

He then examines the U.S. experience since the subprime crisis erupted. Has it followed the typical currency crisis pattern?

A year – almost – after its crisis, the US economy hasn’t endured a similar period of adjustment. Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. Banks have depleted their capital, but I don’t think that they have – in aggregate – shrank their balance sheets...

So no, the United States has not followed the pattern. And no matter how bad you think the U.S. economy has been hit, it could be far worse had external financing dried up.

Brad's point that the typical currency crisis pattern has not held up with the United States reminded me of something I heard about the Early Warning Systems (EWS) that were so popular a few yeas back. Before I mention what it was, let me review the purpose of the EWS by way of the IMF:

The IMF uses econometric models known as early warning system (EWS) models in its efforts to predict currency crises—defined as a sharp currency depreciation or loss of foreign exchange reserves or both—before they occur. These EWS models focus on external volatility and exploit systematic relationships apparent in historical data between variables associated with the buildup to crises and the actual incidence of crises. The variables include the ratio of short-term debt to foreign exchange reserves, the extent of real exchange rate appreciation relative to trend, and the external current account deficit. Both theory and evidence suggest that the higher the value of each of these variables, the greater the probability of a crisis. Extensive tests have been performed to determine which of these empirically based models best fits the data and is the most robust.

The IMF's EWS models focus on a relatively long prediction horizon of 12-24 months to provide countries with enough lead time to adopt corrective policies. The focus is, after all, on prevention. The IMF also keeps an eye on alternative EWS models developed by the private sector and explores variations on the central IMF model. The private sector models, produced chiefly by investment banks, have shorter time horizons because the aim is to guide short-term investment decisions. Among the IMF's alternative models, one focuses on balance sheet variables, notably for the financial and nonfinancial corporate sectors, and another (estimated with annual data) focuses on fiscal variables.

This comes from a 1999 paper, so the EWS models have evolved. Still, the basic premise behind the EWS remains: forecast currency crisis. So here is what I heard about these models. If you plug the United States into these models you find a major dollar crisis happened years ago. That has not happened though the dollar has already depreciated just over 25% over the last 3 years. Still, there are huge economic imbalances that will require further depreciation of the dollar. A sudden collapse of the Bretton Woods II system could turn this need for further dollar depreciation into a dollar crisis. I hope for a different outcome.

Fannie and Freddie Smackdown: The William Poole Edition

William Poole makes it clear how he feels about Fannie and Freddie:

Fannie Mae and Freddie Mac are not essential to the mortgage market; if they were put out of business in an orderly fashion over 5 to 10 years, the market would pick up the business they abandon. Fannie and Freddie exist to provide guarantees for mortgage-backed securities trading in the market. The business is simply insurance.

There are lots of insurance businesses around: property, auto, life and many others. These markets work fine without any government-sponsored enterprises. They are not highly concentrated into a small number of dominant players whose failure would threaten the entire economy; rather, lots of companies compete and spread the risk. Indeed, there are well-established firms in mortgage insurance, but their growth has been stunted by the special advantages Fannie and Freddie enjoy.

[...]

There are more general economic reasons for liquidating Fannie and Freddie, the biggest being that it is very dangerous to maintain such a large role in any market for only two operators. Markets work best when numerous firms compete against each other.

And then there is moral hazard. Knowing they had a federal backstop, Fannie and Freddie held too little capital and the market financed their activities at interest rates very close to those enjoyed by the government. Now we are living through the result. Does it make sense to reconstitute them so that they can engage in a repeat performance?

Fiscal Transfers to the States and the U.S. OCA Status

In a previous post on the givers and takers among the states, I mentioned that it seemed odd that states in the Rustbelt--those states undergoing significant economic hardships--were on average paying more in federal taxes than they were receiving in federal expenditures over the period 1981-2005. I wanted to be more precise about my observations so I plotted the two figures below showing the relationship between federal dollar expenditures per dollar of federal taxes per state and the economic performance of each state. The first measure comes from The Tax Foundation while the second measure is the year-on-year growth rate of the Philadelphia Fed's coincident indicator series. My thinking--influenced by the optimum currency framework--was that federal fiscal transfers should on balance go more toward those states lagging economically. In short, I expected a negative relationship between the two plotted measures. Here is what I found for the period 1981-2005 (click on figures to enlarge):

The above graph does shows the negative relationship that I expected and it is significant at 6%. However, it has a R-squared of only 0.07--only 7% of variation in federal dollar expenditures per tax dollar can be explained by variation in the states economic performance! I redid the graph for years 2000-2005 and found the following:

Here there is no significant relationship and yet the Rustbelt states are really suffering. So at best, there is a significant relationship that explains next to nothing. My priors did not hold up.

These results were interesting to me because they are important in thinking about whether the United States is truly an optimum currency area (OCA). For the United States to be an OCA--and thus be best served by a single currency and monetary policy--states should either (1) share similar business cycles or (2) have the economic shock absorbers of wage and price flexibility, factor mobility, diversified economies, and federal fiscal transfers. In the former case, similar business cycles among the states mean that a national monetary policy, which targets the aggregate business cycle, will be stabilizing for all states. In the latter case, on the other hand, dissimilar business cycles among the states will result in a national monetary policy that is destabilizing—it will be either too simulative or too tight—for some of the states unless the economic shock absorbers listed above are in place. There is ample evidence that there is significant variation among the states' business cycles. So for the United States to be an OCA it is important for the economic shock absorbers to be in place. The evidence above suggest one of the shock absorbers is missing.

Dan is the Man!

Daniel Drezner that is. He had a short piece on Marketplace that speaks to one of the more frustrating conversations I have on regular basis now. It goes something like this: "It must be nice to have your summers off." or "What exactly do you do during the summer time?" My dear friends who ask this question do not seem to appreciate that a lack of teaching does not mean a lack of work--especially for a tenure track professor! That is why I enjoyed Daniel's piece so much. Listen to it and feel the pain of an academic!