regional economist - fall 2011

8/3/2019 Regional Economist - Fall 2011

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A Quarterly Reviewo Business andEconomic Conditions

V. 19, N. 4

October 2011

The Federal reserve Bank oF sT. louis

CeNtral to ameriCas eCoNomy

Dc nd Db

How We Got Here, Where

We Could Goplus a Q&A

Wg Gp

Are Women, Obese Pe

Really Being Shortchan

Is Shadow BaningReally Baning?


2/28

c o n T e n T s

Is Shadow Baning Really Baning?By Bryan J. Noeth and Rajdeep Sengupta

o those who dont know, the term shadow banking probably has

a negative connotation. Tis primer draws parallels between what

has been termed the shadow banking sector and the traditional

banking sectorshowing that they are similar in many ways.

8

The Regional

EconomistOCTOBER 2011 | VOL. 19, NO. 4

3 p r e s i d e N t s m e s s a g e

4 The Debt Debate

in Perspective

By Brett Fawley

and Luciana Juvenal

All the attention given to raising

the U.S. debt ceiling this past

summer might lead some to

believe that spending by the ederal

government only recently became

unsustainable. Hardly. Weve

been on this path a long time.

6 Drivers o the Defcit

and Possible Ways Out

By William R. Emmons

Tis Q&A on the ederal decit is

a preview o the Dialogue with

the Fed that the public is invited

to Oct. 18 at the St. Louis Fed.

14 Gender Wage Gap

By Natalia Kolesnikova

and Yang Liu

Te gender earnings gap has

been declining or at least 30

years and is now at a low o

16.5 percent, according to one

government agency. However,

many studies indicate that the

gap is actually much narrower

perhaps only 4 or 5 percent.

16 Obesity Wage Gap

By Michael . Owyang

and E. Katarina Vermann

Some studies have ound that

the obesity wage gap holds or

women but not men. But the

measure used to determine

obesity is important. Should BMI

(body mass index) be used to

indicate i someone is overweight,

or should a ratio o at to muscle

be used?

18 Immigration Issues:

Beyond Wages

By Rubn Hernndez-Murillo

and Christopher J. Martinek

Any analysis o the impact o

immigration in this country ought

to consider not only what wages

immigrants are willing to work or,

but their skills, occupations and

choice o where to live.

2 0 d i s t r i c t O V e r V i e w

Eighth District Gained,

Not Lost, Jobs Last Year

By Natalia Kolesnikova

and Yang Liu

A recent revision o jobs data by

the Bureau o Labor Statistics

shows the District served by theSt. Louis Fed gained 15,200 jobs in

2010 and did not lose 7,800 jobs,

as announced earlier. Still, the

Districts growth rate remained

below the national average.

2 2 c O m m u N i t y p r O i L e

St. James, Mo.

By Susan C. Tomson

Plentiul green space along

the interstate is what drives the

economy o this small town in

central Missouri. All that land

lured a Wal-Mart distribution

center and was responsible,

at least in part, or a vacuum

companys move o its

manuacturing to the United

States rom aiwan.

25 ecONOmy at a gLaNce

2 6 N a t i O N a L O V e r V i e w

New Data Elevate

Economic UncertaintyBy Kevin L. Kliesen

New GDP gures. New orecasts.

A downgrade by S&P. Uncertainty

increases about the strength o the

U.S. economic recovery.

27 reader exchaNge

The Regional Economist bl

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AQuarterlyReviewofBusinessandEconomicConditions

Vol.19,No.4

October2011

THE FEDERALRESERVE BANK OFST.LOUIS

CENTRALTOAMERICAS ECONOMY

DefcitsandDebt

HowWeGotHere,Where

WeCouldGoplusa Q&A

WageGaps

AreWomen,ObesePeople

ReallyBeingShortchanged?

Is Shadow BankingReally Banking?

Cover illustration dan page

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2 th rgn ecn | October 2011


3/28

One o the challenges we ace as policy-makers is the availability o data toassess the state o the economy in real time.

Many economic data series are released with

delays o weeks or months and are subject

to subsequent revisions that can be quite

sizable and can alter our perceptions o the

economic situation. When ormulating

monetary policy in real time, we must always

keep that in mind.

As a prime example, estimates o thenations gross domestic product (GDP)

undergo multiple revisions as new inormation

becomes available. Te Bureau o Economic

Analysis releases three estimates (advance,

second and third) or each observation o GDP

in the months aer a quarter ends. Tese

estimates are then subject to annual revisions,

which generally cover the three previous

years but sometimes more. Te latest annual

revision, released July 29, demonstrated that

estimates o GDP can change substantially

rom earlier reports.Te revisions to the data included in the

July 29 GDP report create a dierent view o

economic growth in recent years. Based on

these revisions, the 2007-2009 recession now

appears to have been deeper than economists

and other analysts previously estimated. For

instance, while still the largest contraction o

the recession, output during the ourth quar-

ter o 2008 declined by 6.8 percent according

to the prior release but by 8.9 percent accord-

ing to the revised numbers. In addition, the

economy appears to have grown more slowlyduring the rst hal o 2011 than reports

suggested at the time. First-quarter GDP

growth was revised down rom 1.9 percent

to 0.4 percent, and rst-hal growth came in

at just over 1 percent, according to the data

released July 29.1

While the revisions suggest weaker

growth, the anecdotal reports that came in

during the rst hal o 2011 are not consistent

with the idea that the economy grew very

slowly and that growth was actually slowing

down. Corporate prots, or example, were

quite strong during that period. Tis could

mean that GDP will be revised urther in

the uture to reect the stronger anecdotal

reports. Alternatively, perhaps these reports

came rom larger businesses that have some

global presence in Asia or elsewhere outside

the United States. For those companies,

U.S. markets are important, but they are not

denitive or corporate prots. Te incon-sistencies between the revised data and the

anecdotal reports serve as a caution about

interpreting too much rom the data.2When taken at ace value, however, these

revisions possibly had an impact on how

people view the U.S. economys potential out-

put. Te revised GDP data suggest that trend

output growth over the past decade was lower

than previously thought. I, or example,

stock market participants expect lower trend

growth in the uture, they may revalue equi-

ties downward and, thus, sell o stocks. Such

revaluations seemed to have occurred in late

July and early August. U.S. equity markets

experienced large uctuations, and at leastsome o that volatility can likely be explained

by the GDP revisions.

Overall, the July 29 GDP report was a

major piece o news that appeared to alter

expectations o economic growth going

orward. An important point to keep in

mind is that the data may be adjusted again

with other annual revisions, as well as with

the benchmark revisions that occur roughly

every ve years. Tese uture revisions could

end up telling yet another story about eco-

nomic growth in recent years.

As mentioned above, interpreting real-

time data poses a challenge or policymakers

because we know the data can be revised

substantially. Nevertheless, we must rely

upon the inormation available to us, as well

as expectations or uture data, when making

policy decisions. Te St. Louis Fed houses a

real-time database called ALFRED (Archi-

vaL Federal Reserve Economic Data), which

provides vintage versions o economic data

or more than 30,000 series. Having access

to this type o inormation helps research-

ers and policymakers evaluate past policy

actions. o do so properly, we should use the

data that a policymaker had at the time o a

given decision rather than revised data that

are available several years later.3

Even though policymakers do not have thebenet o revised data when reaching deci-

sions, we can learn rom economic history.

My colleagues at the Fed and I use many

pieces o economic inormation, including

the latest vintage o GDP data, to shape our

perceptions about the U.S. economy as we

ormulate monetary policy to achieve the

Feds dual mandate.

t l nnl von,

l Jl 29, on

o gdp n

n bnll o

l o.

Economic Data:

Appearances Can Be Deceiving

P r e s i d e n T s M e s s a g e

James Bullard, pn n ceO

l rv Bnk o s. Lo

E N D N O E S

1 Tese growth rates are annual rates o change.2 Further illustrating the i nconsistencies, second-quarter

GDP was revised down rom 1.3 percent (the advance

estimate) to 1 percent (the second estimate) in the

Aug. 26 report.3 For example, see Orphanides, Athanasios. Monetary

Policy Rules Based on Real-ime Data.American Economic

Review, September 2001, Vol. 91, No. 4, pp. 964-85.

th rgn ecn | www.stlouised.org 3


4/28

By Brett Fawley and Luciana Juvenal

he global nancial crisis and result-ing Great Recession accelerated bothnational and international debate over the

sustainability o U.S. government spending.

Tis is the direct consequence o the crisis

pushing the U.S. ratio o gross debt to GDP

over 90 percent, due both to large increasesin government spending and large decreases

in tax revenue. (See Figure 1.) Te resh

sense o urgency that this has ignited to

solve the debt situation, however, obscures

the act that U.S. government spending

was no more sustainable prior to the Great

Recession than it is now. Put another way,

the recent large decits change almost

nothing about the long-term scal prospects

o the United States. Te overwhelming

obstacle to a sustainable scal path or the

United States, regardless o the size o thecurrent debt, remains health-care spending.

The Long-Run Outloo

Te basic picture o the U.S. debt situation

is presented by the Congressional Budget

Oce (CBO) in its Long-erm Budget Out-

look.1 Figure 2 shows the CBOs orecast o

ederal spending on net interest payments,

Medicare/Medicaid and Social Security

under two dierent scenarios. Te primary

dierences between the extended-baseline

scenario (solid lines) and alternative scenario(dotted lines) are the assumptions made

regarding growth in government revenue.2

Te extended-baseline scenario adheres, in

the words o the CBO, closely to current

law: Te 2001 tax cuts expire, the reach

o the alternative minimum tax grows, the

tax provisions o the recent health-care

legislation remain in place and the tax code

remains largely in place. Under this scenario,

the increase in health-care spending and

Social Security is roughly oset

by the steady growth in tax revenue.

In contrast, the alternative scenario takes

the opposite assumptions o the baseline

and assumes that tax revenue will remain

near its historical average o 18 percent o

GDP. From Figure 2, three key inerencescan be made:

1. I growth in government spending on

health care and Social Security is matched

by growth in government revenue, the cost

o servicing the debt, and moreover the

debt itsel, will largely stabilize as a percent

o GDP rom 2020 to 2030. In other words,

the current level o the debt is not by itsel

an obstacle to scal sustainability.

2. I, on the other hand, the government

increases spending on health care andSocial Security without raising addi-

tional revenue, the debt, and the cost o

servicing the debt, will skyrocket toward

unmanageable levels.

3. As a share o GDP, outlays on Social

Security are expected to largely stabilize

by 2030. Hence, the overwhelming drivero increases in government spending is

health care.

Health care is oen thought o as a supe-

rior good: Te wealthier that individuals

are, the greater their share o income that

they would preer to spend on health care.3

Tereore, it is sensible that the United

States would wish to spend a larger and

larger raction o income on health care.

Te reality, though, is that rising health-care

spending in the absence o revenue increasesis unambiguously unsustainable, which

was both true and well-documented prior

to the current debt crisis.4 At some point,

tough decisions have to be made regarding

whether health care is a universal right, and

i it is, who is going to pay or it.

The Current Situation

As seen in Figure 2, net interest payments

and by association the debt level, should

largely stabilize and even begin to all as a

raction o GDP, provided uture spendingincreases on health care are met by uture

revenue increases. Obviously, one critical

part o this equation is GDP growth.

Historically, GDP growth has been the

key ingredient or reducing the eective size

o the U.S. debt. Figure 3 shows that the

U.S. gross debt-to-GDP ratio declined rom

a post-war high o over 120 percent in 1946

to just under 38 percent by 1970. Figure

3 also shows that this decline was not due

Why Health Care Matters

and the Current Debt Does Not

Corbis

FIGURE 1

The U.S. Federal Debt

1950 1960 1970 1980 1990 2000 2010

120

100

80

60

40

20

0

Gross Debt

Debt Held by the Public

PERCENT

OF

GDP

sourCe: oc Mm b.

d 2008 hh 2010 m. d h h c -m (..,m h h m; h m chh h sc sc ) c w h m.


T h e d e B T c r i s i s


5/28

to the government running surpluses, but

almost entirely due to GDP growth: Te

average budget gap was a decit equal to

a hal percent o GDP, as the government

ran decits in over two-thirds o the years

covered. But because GDP grew on average

3 percent per year over this period, the ratio

o gross debt to GDP ell precipitously.

One air charge is that, in the current

situation, we cannot rely on GDP growth to

magically wipe away the debt. In particular,

the assertion that a causal link exists between

high debt and low growth is particularly

worrisome, as it would imply a reinorcing

cycle between low growth and rising debt.5

But this is where it is important to remember

that the government diers critically rombusinesses and individuals.

As the sole manuacturer o dollars, whose

debt is denominated in dollars, the U.S.

government can never become insolvent, i.e.,

unable to pay its bills.6 In this sense, the gov-

ernment is not dependent on credit markets

to remain operational. Moreover, there will

always be a market or U.S. government debt

at home because the U.S. government has

the only means o creating risk-ree dollar-

denominated assets (by virtue o never acing

insolvency and paying interest rates over theination rate, e.g., IPSreasury Ination-

Protected Securities). ogether with the

unusually high, but manageable, level o the

current debt, these acts imply that the cur-

rent U.S. government can wait out any short-

term economic developments until long-run

growth is restored.7 Further, without an

immediate need to drastically reduce the

debt, the mechanism between high debt and

slow growth loses most o its credibility.

O course, as we have already seen with

health care, the government does not have

the ability to systematically increase spend-

ing without any regard or unding it. And

government borrowing can be extremely

costly. Te cost o government borrowing

is the crowding out eect: Investment

unds mobilized by the government cannot

be used in the private sector. It is in this

ramework, though, that classical economic

theory argues the government should

neither borrow nor lend, not because it has a

moral obligation to run balanced budgets,

but because it must consider the cost o

diverting investment unds away rom

potentially more-productive uses.

In an economic environment like todays,where real interest rates are practically zero,

i not negative, and the unemployment rate

remains high, the opportunity cost to society

o the governments mobilizing capital and

labor is unprecedentedly low: Te private

sector is not ully utilizing these resources;

so, no opportunities are lost i the govern-

ment uses them. Assuming investment proj-

ects with a positive net expected return exist,

as they surely do, there has hardly been a less

costly time to start such projects.8 What no

country can aord, however, are permanentincreases in government spending without

increasing tax revenue.

Luciana Juvenal is an economist and BrettFawley is a senior research associate, both atthe Federal Reserve Bank o St. Louis. Seehttp://research.stlouised.org/econ/juvenal/or more on Juvenals work.

1945 1950 1955 1960 1965 1970

10

5

0

5

10

15

130

120

110

100

90

80

70

60

50

40

30

GDP Growth (left axis)

Budget Gap (left axis)

Gross Debt (right axis)

BUDGETGAP/GDP

GROWTH(%

GDP)

GROSSDEBT(%GDP)

FIGURE 3

The Evolution o the U.S. Debt: 1946-1970

sourCes: b ecmc a oc Mm b.

FIGURE 2

sourCe: Cbo.

note: th h Cbo c wh c h gdp, wh h h

Cbo c c h gdp. s n. 2 c w c.

2010 2020 2030 2040 2050 2060 2070 2080 2090

45

40

35

30

25

20

15

10

5

0

Net Interest Payments

Medicare/Medicaid

Social Security

PER

CENT

OF

GDP

E N D N O E S

1 See Congressional Budget Oce.2 In addition to altering its assumptions about

tax revenue in the alternative scenario, the CBO

relaxes some o the assumptions that it makes

regarding the u ll implementation o the recent

health-care bill. Tis slightly modies its projec-

tions or health-care spending, though this is

o secondary importance to the tax revenue

assumptions. Te alternative scenario contains no

changes in assumptions regarding Social Security

so, the solid and dotted lines ully overlap.3 See Scheiber.4 See Wasylenko.5 See Reinhart and Rogo.6 echnically, the debt ceiling could render the

government unable to pay its bills, but the law has

little credibility because enorcing it would almost

certainly cause more harm than good.7 Te long-run GDP growth assumed by the CBO is

a airly conservative 2.1 percent.8 Note that we are drawing a strict disti nction

between investment projects, e.g., inrastructure,

which enhances the capacity o the economy and

will li kely be needed down the line, and current

spending, which only provides services today.

R E F E R E N C E S

Congress ional Budget Oce. CBOs 2011 Long-

erm Budget Outlook. June 2011. See www.cbo.

gov/doc.cm?index=12212

Reinhart, Carmen M.; and Rogo, Kenneth S.

Growth in a ime o Debt. National Bureau o

Economic Research Working Paper No. 15639,

January 2010. See www.nber.org/papers/w15639

Scheiber, George J. Health Care Expenditures

in Major Industrialized Countries: 1960-1987.

Health Care Financing Review, Summer 1990,

Vol. 11, No. 4, pp. 159-67.

Wasylenko, Michael. Health Care and the Looming

Fiscal Crisis in the United States. Revista Chilena

de Administracion Publica (Chilean Journal o

Public Administration), June 2007, Issue 9,

pp. 65-78. See http://sura ce.sy r.edu/cgi/

viewcontent.cgi?article=1003&context=ecn

The Congressional Budget Ofces Long-Term Outloo or Federal Outlays



6/28

Te St. Louis Feds new discussion series

or the public, Dialogue with the Fed:

Beyond odays Financial Headlines ,

is under way. Economists and others

rom the Bank talk about pressing issues

related to the economy, aer which theaudience asks questions. William R.

Emmons, an economist in the Banking

Supervision and Regulation division,

will be the eatured speaker Oct. 18.

His talk will be titled Whats Driving

the Federal Budget Defcit, and What

Can We Do About It? What ollows

is a preview o his talk, based on ques-

tions he oen receives.

Q. Do we really have a problem with ourederal budget, or has this been blown out o

proportion?

A. We really do have a problemin boththe short-term and long-term. Te reasons

behind the ormer are, o course, the recent

recession and nancial crisis; their sever-

ity led to a huge expansion o the decit.

It would have been virtually impossible

to prevent this large increase in the decit

aer such an economic and nancial shock.

Tats because our laws include many provi-

sions that operate automatically (automaticstabilizers) with no input rom Congress

or the president unless they choose to revise

those lawswhich they would be loath to do

during a recession. Examples o spending

categories that increase automatically when

the economy slows include unemployment

insurance and income-based benets or

health care and ood. On the other side o

the ledger, tax payments by individuals and

businesses go down when their incomes all.

Q. How much are we talking about?

A. Automatic stabilizers were $34 billion(7 percent o the decit) during scal year

2008, $312 billion (22 percent o the decit)

during 2009 and $359 billion (28 percent o

the decit) during 2010. (Te total decits

or these years were $459 bil lion, $1.413trillion, and $1.294 trillion, respectively; the

Congressional Budget Oce [CBO] expects

the 2011 decit to come in at about $1.284

tril lion.) Tese amounts wil l taper o i and

when the economy picks up steam.

Q. But that still leaves about three quar-ters o the 2009 and 2010 defcits that werent

automatic. What else was going on?

A. Congress and the president agreedto signicant increases in ederal spend-

ing and decreases in tax revenues intendedto cushion the blow o the severe recession

and prevent the economy rom sliding into

a repeat o the Great Depression. Tese

included increased inrastructure spending,

substantial assistance or state and local

governments, and purchases o nancial

assets and entire nancial institutionsor

example, Fannie Mae and Freddie Mac.

Some types o taxes were decreased, and the

large tax cuts o President Bushs era that

were scheduled to expire at the end o 2010

were extended.

Q. Help me with the mathhow much do

these discretionary defcits amount to?

A. Te discretionary components o theederal budget decit during scal years

2008, 2009 and 2010 were $425 billion,

$1.1 trillion and $935 billion, respectively.

Q. And what is driving the long-term

ederal budget problem?

A. wo main actors, according to theCBO: an aging population and the rapid

increase in spending on health care. (See

related article on pp. 4-5.)

Q. Which budget problem is more serious

the short-term or the long-term?A. Te long-term. In the short term,

renewed economic growth and a ew budget

adjustments would bring the decit back

down to a reasonable level. Investors both

at home and abroad show limited concern

about short-run decits.

On the other hand, we know the long-

term problem is being taken more seriously

by investors because, in part, Standard &

Poors downgraded the reasurys long-term

debt recently. And nancial history is ull

o countries that let their decits run out ocontrol to the point that the interest on the

debt itsel starts to compound at a righten-

ing pace. At some point, these countries

cannot raise enough tax revenue or borrow

rom investors, and they deault.

Q. Couldnt the government refnance itsdebt at low interest rates or the long haul,

just as an individual combines his credit-card

and other debts and takes out a home equity

loan at a fxed low rate or 30 years?

A. Te reasury could, in principle,borrow a lot more at very long maturitiesto lock in current rates. It is unlikely to do

that. Among the reasons:

a) Te reasurys debt-management strat-

egy targets an average maturity o closer to

ve or six years. Tis lowers the short-term

cost o borrowing (shorter maturities are

cheaper to issue) and conorms to long-

standing practice and market expectations.

Te reasury believes that it can minimize

with William R. Emmons

Qt bt t Bt dft

t u.s. h n ey aw


d i a l o g u e W i T h T h e F e d


7/28

its borrowing costs over time by maintain-

ing deep and liquid markets all along the

reasury yield curve, rom a ew days out

to 30 years. As or going urther out50 or

100 years, or exampleI dont think such a

move would conorm to the reasurys strat-

egy. It would also be dicult to maintain

liquid markets at maturities that extend that

ar into the uture.

b) Tere is no guarantee that current

long-term rates would be avorable or the

reasury. Long-term rates could go lower

look at Japan.

c) Long-term rates are comparatively

expensive today. Te reasury pays 3.5

percent to borrow at 30 years, but it pays

essentially zero to borrow or a ew months.

Q. What is the tipping point or the debtthe point where, as you say, defcits run out

o control and interest on the debt starts tocompound at a rightening pace?

A. No one really knows. Some well-known economists have been preaching

that a debt-to-GDP ratio o 90 percent is the

tipping point, based on their study o other

countries debt crises. Critics o these econ-

omists, however, say that this is a simplistic

and nave number based on countries that

are not relevant or comparison to the U.S.

As a counter-example, Japan has outstand-

ing government debt o over 200 percent o

GDP, and that country has had no trouble todate in borrowing at very low rates.

Another approach to this question is to

look at the very long termsay, 50 or 100

years out or moreand dene the deter-

minants o a sustainable long-run debt

roll-over strategy. Economists have done

this and have concluded that a country

with a primary budget balance o zero (the

budget balance excluding interest payments)

can roll over its debt indenitely, however

large it may be, as long as the average inter-

est rate it pays is no higher than the growthrate o its potential revenueessentially,

the growth rate o the economy. Looking

back, the U.S. has been in this position or

signicant parts o its history.

o be in this position again, we would

need to bring our primary budget decit

down and hope that the economy continues

to grow while investors continue to accept

very low reasury interest rates. Using scal

year 2011 (Oct. 1, 2010-Sept. 30, 2011) as an

example, the growth rate o nominal GDP

was 3.7 percent (through the second quarter

o 2011), and the average rate o interest

paid on the outstanding debt was about 3

percent. Tus, i these rates persisted inde-

nitely, we could aord a primary decit o

about 0.7 percent o GDP each year and still

roll over our debt successully, even aer

making interest payments.

Unortunately, our primary decit

during scal 2011 was about 7 percent o

GDPar too large to be covered by our

modest nancing advantage relative to GDP

growth. Te point remains, however, that

it is conceivable the U.S. could roll over a

very large stock o outstanding debt orever

under the right circumstances. In act, the

CBO projects that our primary decit will

be close to zero by scal year 2014 i current

policiesincluding the expiration o all

temporary tax cuts and other scheduledprovisionsare carried out.

Q. Tese discussions always end up withthe experts saying that the only solution is

to trim Medicare/Social Security or baby

boomers. Is that true?

A. Yes, unless we are willing to raisetaxes a great deal, which would harm the

economy. Te aging population and ederal

spending on health care are the two issues

the CBO highlights in its long-term budget

outlook. Te way the CBO explains it, theaging o the population creates big budget

pressures or a ew decades, but then it

recedes a bit. Te aging o the population

goes beyond the baby-boom generation,

however, because even aer all baby boom-

ers have died, demographers expect the

remaining population structure to be per-

manently older on average. Tats because

people will keep living longer, and the birth

rate is at or declining.

So, the aging population is a huge issue

until about 2035; then, it becomes just abig issue.

Federal health-care expenditures, on the

other hand, threaten to grow aster inde-

nitely than the economy and tax revenues

unless we nd a way to bring them under

control.


o oc. 18, cm Wm r.emm b s r w c h c.

o n. 21, Chh J. W,ch c, w c hmc hh

mm .

Economic Inormation or All

t l rv Bnk o s. Lo o-

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bn v, n, bnk, o-n vlo n nl bl.

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THE FEDERAL RESERVE BANK OF ST. LOU IS : CENTRAL TO AMERICAS ECO N O MY | STLOU ISF

CE NTRAL

N E W S A N D V I E W S F O R E I G H T H D I S T R I C T B A N K E

FALL2011

FEATURED I N TH I S I SSUE: EarningsGrowthStalls | LocalHouse-Price ChangesNowFollowing Nation

By Gary S.Corner

The domesticagriculture industryhasbeenthriving overthe lastdecade. According tothe U.S.Depart-

ment oAgriculture (USDA),six othe past eight yearsrank among the

top 10 income-producing yearsorthe industry (adjustedor ination)since 1980.Ascommodity pricesandarm incomessoared, armlandprices

Agriculture Banks Are OutperformingTheir Peers, But How Long Will It Last?

alsosurged.Ancillary agriculturalbusinesses,such asarm equipment

manuacturersan ddealers, have alsobeneftedrom recent arm prosperity.

Asa result ostrong industry con-

ditionsin recent years,agriculturebankshav e generally outperormed

community bankswithout anagri-culturalocus.The leveloproblem

continuedon Page 7

AgricultureBankPerformanceAssessment

DistrictAgBanks

(137)1DistrictNon-AgBanks

(483)

U.S.AgBanks

(1,517)

U.S.No

(

2011 2010 2011 2010 2011 2010 2011

ROA 1.05% 0.73% 0.80% 0.77% 1.06% 0.96% 0.49%

NonperformingLoans + OREO /Total Loans + OREO2 2.39 2.37 4.27 3.71 2.51 2.56 5.66

Tier 1 Capital Ratio 10.31 10.41 9.70 9.44 9.91 9.93 9.69

Net Interest Margin 3.97 4.00 3.88 3.80 3.91 3.99 3.84

Average CAMELSRating3 1.89 1.84 2.18 2.16 1.89 1.86 2.44

Provision Expense / A verage A ssets 0.36 0.64 0.39 0.45 0.24 0.41 0.54

L oa n Lo ss R es er ve / N on pe rf or mi ng Lo an s 9 5. 21 8 6. 74 6 8. 29 7 0. 38 9 3. 12 7 9. 87 5 4. 71

A gP ro du ct ion Loa ns / Tot al L oan s 1 1.6 0 1 2.0 9 1 .9 4 2 .0 4 2 0. 96 21 .7 5 1 .4 0

Farmland Loans /Total Loans 25.17 25.46 5.21 5.21 21.26 20.33 3.00

Total Ag Loans / Total Loans 36.77 37.55 7.15 7.26 42.22 42.08 4.40

SOURCE: Reports oConditionand Income orInsuredCommercial Banks. This assessmentcovers onlybanks withless than$1billioninassets.

NOTES: 1 The Federal Reserves EighthDistricthas 137agriculture banks, withmosthavingless than$1 billioninassets. The average assetsize oture bank nationwide is $128million. Abank is defnedas an agriculture bank ithe combinedagricultural productionandarmland loans

25percentor more oits total loans.

2 The nonperormingloans + OREO(otherreal estate owned)ratio measures the percentage oproblem loans andreal estate property heldb

ateroreclosure. Highpercentages othese types oassets undermine abanks healthandseverelyimpairearnings.

3 CAMELSstands orthecompositesupervisoryratingorCapital,AssetQuality,Management,Earnings,LiquidityandMarketSensitivity.

To keep abreast of this series,

see www.stlouisfed.org/dialogue

th d wh h Fw s. 12. J sch, c b

s r,c mh c c.


8/28


F i n a n c i a l s Y s T e M

By Bryan J. Noeth and Rajdeep Sengupta he term shadow banking has beenattributed to 2007 remarks by econo-mist and money manager Paul McCulley

to describe a large segment o nancial

intermediation that is routed outside the bal-

ance sheets o regulated commercial banks

and other depository institutions. Shadowbanks are dened as nancial intermediaries

that conduct unctions o banking without

access to central bank liquidity or public sec-

tor credit guarantees.1 As shown in Figure 1,

the size o the shadow banking sector was

close to $20 trillion at its peak and shrank

to about $15 trillion last year, making it at

least as big as, i not bigger than, the tradi-

tional banking system.2 Given its size and

role in the nancial crisis, it would be useul

to understand the mechanics o shadow

banking. o do so, some basics o traditionalbanking need to be understood rst.

Simply put, banks are intermediaries that

obtain unds rom lenders in the orm o

deposits and provide unds to borrowers in

the orm o loans.3 Te principal unction

o a bank is that omaturity transorma-

tioncoming rom the act that lenders

preer deposits to be o a shorter maturity

than borrowers, who typically require loans

or longer periods. It is important to point

out that, because o sudden liquidity needs o

individual agents or businesses, this unction

cannot be perormed by individual agents or

businesses alonetherein lies the rationale

or a bank. Banks are able to achieve this

transormation by exploiting the act that

only a small raction o depositors haveliquidity needs at a given time. Tereore, the

bank can store a small raction o its deposits

in the orm o liquid assets (readily convert-

ible to cash) and lend out the rest in the orm

o term (illiquid) loans. Tis unction is

also known as qualitative asset transorma-

tion because, by changing the maturity o its

assets, the bank also changes their liquidity.4

However, by perorming this unction,

a bank is essentially rendered ragile. Te

ragility comes rom the act that even a

healthy bank can be the victim o a bankrun. I all depositors demand their deposits

back, the bank would have to liquidate all

its assets (even those that are not liquid) to

ulll depositors demands. Since almost

no bank can liquidate all its assets within a

short period without suering a loss in value,

a problem o illiquidity can essentially turn

into a problem o insolvency and the collapse

o the bank. Accordingly, depositors are

acting rationally when they withdraw their

t z o o bnkn o lo o $20 llon

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Is Shadow BaningReally Baning?


9/28

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deposits even at the smallest hint o bad

news.5 More oen than not, such bank runs

are hardly limited to just one bank, precipi-

tating what is called a banking panic.

Given their inherent ragil ity, banks typi-

cally require credit enhancements in the

orm o insurance o deposits or emergency

access to unds rom the central bank.6 In

most countries, public unds are the source

o such provisions o emergency unding.

Indeed, the nancial history o the United

States is replete with stories about bank runs

and bank ailures prior to 1934. In that year,

the Federal Deposit Insurance Corp. was

created, ending runs on commercial banks

in the U.S.

However, the end o bank runs does not

imply the end o bank ailures. Indeed,

the inclusion o such credit-enhancement

measures, especially those unded by third

parties, creates a signicant moral hazard orbanks.7 Banks investing in risky loans ben-

et rom higher returns on the slim chance

o success, whereas the taxpayer is le to bail

out depositors in the likely event that the

banks ail.8 Regulations seeking to prevent

such moral hazard require banks to hold

signicantly higher capital or increased

riskiness o loans (assets) on their balance

sheetknown as a risk-weighted capital

adequacy requirement. Banks view rais-

ing such capital as costly and oen engage

in practices that would help prevent themrom having to do so.9 One such practice is

the creation o o-balance-sheet entities to

host some o the banks assets and, thereby,

reduce their regulatory capital require-

ments. Tis practice is oen viewed as one

o the major reasons behind the creation and

growth o shadow banking.

Broadly speaking, credit intermediation

through the shadow banking system is much

like that through a traditional bankit ul-

lls the principal unction o qualitative

asset transormation. However, unlike tradi-tional banking, which involves a simple pro-

cess o deposit-taking and originating loans

that are held to maturity, shadow banking

employs a much more complicated process

to achieve maturity transormation. At the

deposit end o the shadow banking system

are wholesale investors (providers o unds)

using the repo marketand money market

intermediaries such as money market mutual

unds (MMMFs) to provide short-term

loans that are essentially withdrawable

on demand. At the loan origination end

are nance companies and even tradi-tional banks that engage in the activity o

originating loans, much like the traditional

banking system.

Te shadow banking system intermedi-

ates between the ultimate consumer o unds

(borrower) and the wholesale investor o

unds, whose liquidity needs may preclude

long-term investments. Shadow banking

comprises a chain o intermediaries that are

engaged in the transer o unds channeled

upstream in exchange or securities and loan

documents that are moving downstream.Tereore, what was once accomplished

under a single roo in the traditional bank-

ing system is now done over a sequence o

steps in the shadow banking system, each

perormed by specialized entities that are

not vertically integrated.

The Deposit Endo the Shadow Baning System

Most advanced economies have solved

the problem o bank runs by the creation o

deposit insurance. In 1980, deposit insur-ance in the U.S. was capped at $100,000;

aer the crisis, this limit was raised to

$250,000. Tis meant that the demand or

sae, short-term investments rom large,

cash-rich nancial and nonnancial com-

panies remained unullled. Te shadow

banking system ullled this demand in two

waysboth o which made extensive use o

widely available nancial securities.

Te rst o these arrangements uses repo,

1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007

$25,000

$20,000

$15,000

$10,000

$5,000

$0

Shadow Bank Liabilities

Traditional Bank LiabilitiesBILLION

S

Shadow Ban vs. Traditional Ban Liabilities

FIGURE 1

sourCe: F r b/H ac cc m a, ahc, b pz.


10/28


or repurchase, transactions, whereby rms

with surplus cash buy securities or cash only

and then resell them back aer a short term.

Eectively, this repo transaction is a short-

term cash loan to the seller o the security,

with the security acting as collateral on the

loan. Repo transactions can be open-endedand rolled over on a daily basis, making them

analogous to deposits at a traditional bank

that are withdrawable on demand. However,

unlike demand deposits, which derive their

saety rom deposit insurance, repo transac-

tions derive their saety rom the underlying

security that is the collateral on the loan. In

the event o deault on the loan, the lender

retains the right to sell the security in the

open market and collect the proceeds.

o enhance the saety o the transactions,

repos are overcollateralizedthat is, theloan amount is typically less than the ace

value o the securities used as collateral. In

this manner, overcollateralization imposes

a haircut on the repo, a haircut that var-

ies with the credit risk on the security put

up or collateral. Naturally, haircuts on

repo transactions using reasury securities

are lower than haircuts using comparable

private-label securities.

Te second alternative or cash-rich

investors is to purchase shares in money

market mutual unds. In MMMFs, inves-

tors pool unds to invest in high-quality

short-term securities o the government and

corporations. Notably, investments (shares)

in MMMFs are withdrawable on demand.

Te saety o investments in MMMFs comes

rom the act that the securities they invest

in are regulated to be o high quality and

short maturity, such as reasury bills and

highest-grade commercial paper. While

reasury bills are regarded as securities with

no credit risk, commercial paper is backed

by assets that possess some credit risk. o

alleviate concerns or investors, Rule 2a-7 o

the Securities and Exchange Commissions

Investment Company Act o 1940 restricts

the quality, maturity and diversity o invest-

ments by MMMFs.

Cash-rich investors looking or sae invest-

ments that are withdrawable on demandcan either purchase shares in MMMFs that

are redeemable on demand or can purchase

securities under a repo agreement, whereby

the seller promises to purchase the securi-

ties back at a later date. Te two avenues are

somewhat dierent. Investments in MMMFs

are in the orm o a continuing contract with

variable returns. On the other hand, a repo

transaction is a one-time contract with xed

returns.

The Loan Origination Endo the Shadow Baning System

Tis section reers to the processes by

which the securities used in the deposit end

o the system are created, either to be used as

collateral in a repo transaction or as invest-

ments or MMMFs. Te processes described

below are a simple prototype o numerous

schematics involved in the creation o such

securities. In practice, the chains used in

warehousing, securitization and servicing

can be signicantly more complicated than

the illustrations given below.Financial intermediation has moved rom

an originate-to-hold model o traditional

banking to an originate-to-distribute model

o modern securitized banking. Economist

Gary Gorton argued in a book last year that

deregulation and increased competition in

banking rendered the traditional model o

banking unprotable. In modern banking,

origination o loans is done mostly with a

view to convert the loan into securitiesa

The Creation o Securities rom Loans

FIGURE 2

l dcm

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Bw Bw

Bw

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inv inv

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nd cc ng pcd

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pc pup vhc (sPV)

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LOAN PURCHASE PRICE

OFFERING PROCEEDS

NET OFFERING PROCEEDS

The diagram hw m,- c c

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11/28

practice called securitization , whereby the

transaction, processing and servicing ees

are the intermediaries principal source

o revenue.

Figure 2 illustrates the process o convert-

ing loan originations into nal securities.

Te starting point in this process is the origi-

nation o loans such as auto loans, mortgages

and student loans by regulated commercial

banks and unregulated nance companies.

Under the traditional model o banking, this

loan would reside on a banks balance sheet,

with the bank holding capital against the

loan. Under the securitized model o bank-

ing, the bank arranges to sell the loan.

Te second step o the process involves

warehousing the loan. Tis includes a ware-

house bank that purchases loans rom one or

more originators to orm a pool o such loans.

Te warehouse bank is also known as the

aggregator, seller or sponsor. In some cases,this entity can be the same as the origina-

tor. ypically, this nancing occurs in the

orm o an extension o a line o credit rom

the warehouse bank to the originator o the

loan (a nance company or a small commu-

nity bank) that closes on the loan with such

unds. Te loan documents are then sent

downstream to the warehouse bank to serve

as collateral or the line o credit.

Te third step in the process involves a sale

o the pooled loans to an administrator, typi-

cally a subsidiary o a large commercial orinvestment bank. Te role o the administra-

tor is to purchase the loans rom the aggre-

gator and create the special purpose vehicle

(SPV), which would nally hold the loans.

Oen, the administrator o the SPV receives

a ee or services rendered. Te SPV issues

securities against loans held on its portolio.

(See sidebar on Page 12.)

Te ourth step involves the sale o the

securities created by the SPV. Almost

always, the securities are not sold directly by

the administratorthe creator o the trust.ypically, the administrator sells the cer-

ticates o the trust to the underwriter. Te

underwriter, which is generally an invest-

ment bank, purchases all such securities

rom the administrator with the respon-

sibility o oering them up or sale to the

ultimate investors. Notably, the underwriter

can even retain some o these securities in

its own portolio. Retaining the riskiest

securities is oen viewed as a mechanism to


t o no lon- lon nn

k no nn o o n o

onbl lo k bl on n.

signal the quality o those on sale.

Te h and nal step o the process

involves the purchase o securities by the

investor. Te investor is then entitled to

receive monthly payments o principal and

interest on the securities rom the SPV in

their order o priority. Te order o priority

on the payment o principal and interest is

determined by payment rights accorded to

investors, depending on the class or tranche

o security certicates purchased. Te order

o payment is determined in advance and

stated on the indenture (legal document) that

circumscribes the deal o securities generated

in the process. At this stage, the ultimate

investors o such securities can hold them

on their balance sheet, sell them or even use

them as collateral in a repo arrangement.

Is Shadow Baning Really Baning?

Te ve steps above describe the simplestprocess o securitization by which securities

are created rom originated loans. In some

cases, segments o the process are repeated

to create more securities. ypically, the

class o securities issued depends on the

maturity and type o underlying collateral

(loans originated upstream). For example,

mortgage-backed securities that are backed

by residential or commercial mortgages typi-

cally have longer maturities than does asset-

backed commercial paper (ABCP) that is

typically backed by loan receivables or credit

card receivables.10

MMMFs are among the principal investors

in short-term ABCP. As mentioned above,

MMMFs nance such investments with

shares that can be redeemed on demand. On

the other hand, repo transactions employsecurities o longer maturity as collateral

or short-term borrowings o cash. In both

cases, the liability ormed is theoretically

withdrawable on demand and o shorter

maturity than the assets nanced. In this

way, the mechanics o the shadow banking

system typically resemble the unctions o a

commercial bank.

In the creation o securities, the cash

proceeds rom the sale o securities are

passed upstream to all participating enti-

tiesadministrator, aggregator and nally

to the originator o the loans. At each stage,

thereore, each participating entity relies on

the sale o the securities and loan docu-

ments or revenue. In addition, almost all

o the participating entities require sources

o short-term unding. Tis can arise or

two reasons. First, as described earlier, the

maturity on the securities can be o a shorter

length than the maturity o the loans, requir-

ing the entity to roll over the securities or use

short-term unds to pay investors. Second,

at each stage in the process o securitization,

the need or short-term unding arises in the

interval between the purchase o loans and

their subsequent sale downstream.

It has also been observed that all o the

entities typically use a whole host o short-

term instruments, like nancial commercial

paper, ABCP and repo transactions, to ullltheir short-term unding requirements.11 o

the extent that each entity uses short-term

unding in the creation o assets (loans and

securities) o longer maturity, these enti-

ties perorm the unctions o a bank. In

this sense, individual entities o the credit

intermediation process ulll the unctions

o banking.

Moreover, the process as a whole trans-

orms longer-term loans with signicant

credit risk (such as the origination o

mortgages upstream) into instruments o

shorter maturity and o considerably lower

risk that are redeemable on demand (such as

investment shares in MMMFs). In so doing,

the credit intermediation process as a whole

mimics the unction o a bank.

Shadow Baning and theFinancial Crisis o 2007-2008

Given the discussion at the beginning

o this essay, an obvious corollary that ol-

lows is the ragility o the shadow banking

system. In traditional banking, the ragility

originates in a run by the banks depositors.

In securitized banking, the run comes rom

continued on Page 13


12/28

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t sl po Vl (spV)

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(vbl)o on olln b.

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redit

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The Special Purpose Vehicle and Conduit

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Tranching o Securities in a Waterall Structure

FIGURE 4

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liquidity

support

Fees


13/28

the deposit endthe providers o whole-

sale unding to the shadow banks. Te two

markets in which such runs are most likely

are the repo market and the commercial

paper market.

Te evidence on runs in the markets or

wholesale unding demonstrated the parallel

between traditional bank runs by depositors

in the banking panics prior to 1934 and the

recent panic in credit markets that relied on

wholesale unding. As wholesale unding

dried up or troubled shadow banks, they

were orced to sell o assets in order to meet

liquidity demands o investors. Such a re

sale o assets lowered the prices o assets

on similar collateral throughout the mar-

ket, raising the cost o unding or healthy

shadow banks precipitously.

Tis trend was rst pointed out or therepo market in a series o papers that are

summarized in work by Gorton. In the

interdealer repo market, a run occurred

primarily through increased haircuts on the

securities posted as collateral.12 In the case

o some securities, especially those backed

by troubled mortgage loans, the haircuts

were close to 100 percentimplying that

these assets were no longer eligible or repo

transact ions. An increase in the haircuts on

the repo implies an increased demand or

collateral on the same loan or, conversely, areduction in the supply o unds or a given

amount o collateral. Since the supply o

collateral in the entire shadow banking sys-

tem is xed over the short run, this meant

that there was a signicant liquidity crunch

(shortall in the supply o unds) and a steep

rise in the cost o unding through repo

transactions.

In the case o unding through MMMFs,

the panic was witnessed in two major

shocks to the commercial paper market in

2007-2008. Te rst shock came aroundJuly-August 2007 with the collapse o certain

nancial entities that had invested heavily

in subprime mortgages. Tis led investors

to question the quality o even highly rated

ABCP. As a result, the spread o ABCP over

the ederal unds rate increased rom 10 basis

points beore the shock to 150 basis points in

the days aer the shock.

Te second and more severe shock

occurred with the collapse o Lehman

Brothers in September 2008. Tis led to a

direct deault on commercial paper issued

by Lehman Brothers, $785 million o which

was held by the Reserve Primary Fundone

o the largest MMMFs, with more than $65

billion in assets. Needless to say, the news

o exposure triggered a run on this und

and quickly spread to other MMMFs. o

stem the run on MMMFs, the U.S. reasury

announced a temporary deposit insurance

covering all money market instruments only

three days aer the collapse o Lehman.

Conclusion

Te reader may question the rationale

behind the development o the shadow bank-

ing system and all its components. While

some analysts have asserted that the shadow

banking system is redundant and ine-

cient, it is not dicult to see the benets osecuritized banking. Securitization allows

or risk diversication across borrowers,

products and geographic location. In addi-

tion, it exploits benets o both scale and

scope in segmenting the dierent activities

o credit intermediation, thereby reducing

costs. Moreover, by providing a variety o

securities with varying risk and maturity, it

provides nancial institutions opportuni-

ties to better manage their portolios than

would be possible under traditional banking.

Finally, and contrary to popular belie, thisorm o banking increases transparency and

disclosure because banks now sell assets that

would otherwise be hosted on their opaque

balance sheets.

In summary, the shadow banking system

can be viewed as a parallel systemone that

is a complement to and not a substitute or

traditional banking. Te challenge going or-

ward is to harness the benets and mitigate

the risks and redundancies o such a parallel

banking system.

Rajdeep Sengupta is an economist and BryanJ. Noeth is a research associate, both at theFederal Reserve Bank o St. Louis. For more onSenguptas work, see http://research.stlouised.org/econ/sengupta/


E N D N O E S

1, 2, 11, 14 See Adrian, Ashcra, Boesky and Pozsar.3 Strictly speaking, t his description ts commercia

banks, which along with thri institutions

(savings and loans and credit unions) make up

the set o depository institutions in the U.S.4 In addition, credit intermediation involves

brokerage, whereby the bank also reduces pre-

and post-contractual inormational asymmetries

between the borrower and the lender. Note

that this brokerage unction is not necessarily

exclusive to credit intermediation because many

other intermediaries, such as used-car dealers,

perorm a similar unction. For more, see work

by Greenbaum and Takor.5 Tis key insight developed by Bryant and ormal-

ized in Diamond and Dybvig is arguably the most

celebrated work in banking theory.6 See Diamond and Dybvig.7 See Wheelock and Wilson.8 See Morrison and White.9 See Admati, DeMarzo, Hellwig and Peiderer.

10 See Anderson and Gascon or details on MMMFs

and ABCPs.12 Te evidence is somewhat dierent or the tri-

party repo market. See Copeland, Martin and

Walker or details.13 See Gorton and Souleles.

R E F E R E N C E S

Admati, Anat R.; DeMarzo, Peter M.; Hellwig, Mar-

tin F.; and Peiderer, Paul. Fallac ies, Irrelevant

Facts, and Myths in the Discussion o Capital

Regulation: Why Bank Equity Is Not Expensive.

Research Papers 2065, Stanord University

Graduate School o Business, 2010.

Adrian, obias; Ashcra, Adam; Boesky, Hayley; and

Pozsar, Zoltan. Shadow Banking. Sta Reports

458, Federal Reserve Bank o New York, July 2010.

Anderson, Richard G.; and Gascon, Charles S. Te

Commercial Paper Market, the Fed, and the 2007

2009 Financial Crisis. Federal Reserve Bank o

St. Louis Review, Vol. 91, No. 6, November 2009,

pp. 589-612.

Bryant, John. A Model o Reserves, Bank Runs,

and Deposit Insurance. Journal o Banking and

Finance, Vol. 4, No. 4, 1980, pp. 335-44.

Copeland, Adam; Martin, Antoine; and Walker,

Michael. Te ri-Party Repo Market beore the

2010 Reorms. Sta Reports 477, Federal Reser ve

Bank o New York, November 2010.

Diamond, Douglas W.; and Dybvig, Philip H. Bank

Runs, Deposit Insurance, and Liquidity. Journal

o Political Economy, Vol. 91, No. 3, June 1983,

pp. 401-19.

Gorton, Gary B. Slapped by the Invisible Hand:

Te Panic o 2007. Oxord University Press, 2010.

Gorton, Gary B.; and Souleles, Nicholas S. Special

Purpose Vehicles and Securiti zation. in Carey,

Mark; and Stulz, Ren M. eds., Te Risks o Finan-

cial Institutions. University o Chicago Press, 2007

Greenbaum, Stuart; and Takor, Anjan V. Contem-

porary Financial Intermediation: Second Edition.

Elsevier, 2007.

McCulley, Paul. eton Reections. PIMCO Globa

Central Bank Focus, 2007.

Morrison, Alan; and White, Lucy. Crises and Capi-

tal Requirements in Banking. American Economi

Review, Vol. 95, No. 5, December 2005, pp. 1548-72.

Wheelock, David C.; and Wilson, Paul W. Ex plain-

ing Bank Failures: Deposit Insurance, Regu lation

and Eciency. Te Review o Economics and

Statistics, Vol. 77, No. 4, November 1995,

pp. 689-700.

continued rom Page 11


14/28


P a Y c h e c k s

Gender Wage GapMay Be Much Smaller

Than Most ThinBy Natalia Kolesnikova and Yang Liu

he gap between earnings o male andemale workers has declined signi-cantly over the past 30 years. Te Bureau o

Labor Statistics reports that in 1979 median

weekly earnings o ull-time emale workers

were 63.5 percent o male workers earnings,

implying a gap o 36.5 percent. Te earningsgap dropped to 30 percent in 1989 and to 23.7

percent in 1999. In the second quarter o

2011, the gap reached a low o 16.5 percent.

Despite the accuracy o these numbers,

many researchers believe that the mere com-

parison o median weekly earnings o maleand emale workers presents an incomplete

picture. First, women are likely to work

ewer hours than men, which would make

a gap in weeklyearnings between the two

groups substantial even i their hourlywages

are the same. For this reason, most economic

studies o a gender gap, including all o the

studies reviewed in this article, use hourly

wages instead o weekly earnings as a mea-

sure. Second, many other actors (such as

education and labor orce attachment) could

aect wages. Research suggests that theactual gender wage gap (when emale workers

are compared with male workers who have

similar characteristics) is much lower than

the raw wage gap.

Many studies point out that dierences

in educational attainment, work experience

and occupational choice contribute to the

gender wage gap. Economists Francine Blau

and Lawrence Kahn ound that womens

gains in education and work experience

together accounted or one-third o the

decline in the gap in the 1980s and 1990s.1

As women become more educated, they

have more employment opportunities in

occupations that require higher skills and

pay higher wages.

Such occupational upgrades helped tonarrow the wage gap. However, there are

still signicantly ewer women in highly paid

occupations. Men are more likely to be law-

yers, doctors and business executives, while

women are more likely to be teachers, nurses

and oce clerks. Tis gender occupationalsegregation might be a primary actor behind

the wage gap.

Another important reason or the gender

gap is the dierence in labor orce attach-

ment between men and women. Women are

likely to leave their careers temporarily or

childbirth and raising children. Such leaves

may be associated with a decrease in human

capital and with temporary delays in training

and promotion, which consequently lead to

lower wages. In addition, women are more

likely to work part time and less likely towork overtime than men because o amily

responsibilities.

One study ound that, because women

have weaker labor orce attachment than

men, women tend to be assigned to positions

where turnover is less costly.2 As a result,

women are employed in positions that have a

shorter duration o on-the-job training and

that use less capital. Te study concludes that

these dierences in on-the-job training and

capital in positions lled by men and women,

along with an implied lower value placed

on womens prior labor market experience,

account or a substantial part o the gap in

wages between males and emales.

A recent report prepared or the U.S.

Department o Labor analyzed the genderwage gap using Current Population Survey

(CPS) data or 2007.3 Te report takes into

account dierences between men and women

in educational attainment, work experience,

occupation, career interruptions, part-time

status and overtime worked. Te result is

strikingthese actors explain approximately

three-ourths o the 2007 raw gender hourly

wage gap o 20.4 percent. Te adjusted 2007

gender hourly wage gap is roughly 5 percent.4

o better match women and men with

similar characteristics relevant in a jobmarket, another study used the very detailed

National Survey o College Graduates 1993

(NSCG), which provides inormation not

only on the highest degree attained, but

also on major eld o study and labor orce

experience.5 o explore racial dierences

in the gender wage gap, the study compared

women o various ethnicities with white

men who had similar education, work expe-

rience and academic major and who spoke

English at home. Te study reports a wage

gap o 9 percent or white women, 13 percentor black women, 2 percent or Asian women

and 0.4 percent or Hispanic women. When

the analysis was restricted to unmarried,

childless women only, the wage gap shrunk

to 7 percent or white women, 9 percent or

black women and to virtually zero or Asian

and Hispanic women.

Some researchers believe that it is not

enough to compare wages o similar men and

women. Tey argue that total compensation

p. WinbladH/Corbis

, on lkl o ok o n n,

ol k n weekly earnings bn o o

bnl vn hourlywages .


15/28


(wages together with benets) must be

compared. Women o child-bearing age

may preer jobs with a lower wage but withemployer-paid parental leave, sick leave and

child care to jobs with a higher wage but

without such benets. A study that used

National Longitudinal Survey o Youth 1979

(NLSY79) ound that emale workers were

indeed more likely to receive amily-riendly

ringe benets.6 Some economists believe

that emale workers pay or the benets

they preer by accepting a lower wage. I that

is the case, excluding ringe benets would

exaggerate the actual gender wage disparity.

Economists Eric Solberg and eresaLaughlin applied an index o total compen-

sation, which accounts or both wages and

benets, to analyze how these benets

would aect the gender gap.7 Tey ound a

gender gap in wages o approximately

13 percent. But when they considered totalcompensation, the gender gap dropped to

3.6 percent.

Despite the diculty in measuring the

gender gap in earnings, the topic attracts

much attention o policymakers and pay-

equity advocates. Hopeully, continued

economic research on the subject will add

to a meaningul discussion and will guide

eective public policy.

Natalia Kolesnikova is an economist and YangLiu is a senior research associate, both at theFederal Reserve Bank o St. Louis. See http://research.stlouised.org/econ/kolesnikova/ ormore on Kolesnikovas work.

ho o n nn n e d o nonl ? t B o Lbo s (BLs) o noov n kl nn b o o . o-

nl, Nonl B o eono r ov

b BLs o o 2010. un , bl

o lol l u.s. n nn o 18.8 n

o b BLs o 2010.8 w n n nl n l-

l n n kl nn o n l o

n e l rv d.

aon n e d, akn lo

n nn (18.5 n), ll b n nonl .

gn nn n tnn (19.4 n) n m

(20.5 n) ll n non, l n illno

(22.2 n) 21 n n non. Knk (24.3 -

n), mo (24.8 n) n inn (25.0 n) v

n nn on e d , bo

bov nonl v.

all jo o n e d b n

nn n nonl v. m n nn

o 23.3 n, l Lovll o o 23.4 n. d

akn vn lo n nn on e

d , n n Ll rok 25 n.

s. Lo n on jo o n

d (27.3 n), 48 n n nonl v.

t vlbl o no llo o o

n n on, oonl o, n lbo o n

n n bn n n on n e d on

o n nn n d.

E N D N O E S

1 See Blau and Khan.2 See Barron et al.3 CONSAD Research Corp.4 It is reasonable to believe, thereore, that the

actual gender earnings disparity in the second

quarter o 2011 is closer to 4 to 5 percent rather

than 16.5 percent as presented in the graph.

Put dierently, the current gender gap in average

weekly earnings is about $35.5 See Black et al.6 See Lowen and Sicilian.7 See Solberg and Laughlin.8 In our estimation, the gap is 18.4 percent.

R E F E R E N C E S

Barron, John M.; Black, Dan A.; Loewenstein, Mark

A. Gender Dierences in raining, Capital, and

Wages. Journal o Human Resources, 1993,

Vol. 28, No. 2, pp. 343-64.

Black, Dan A.; Haviland, Amelia M.; Sanders, Seth

G.; and aylor, Lowell J. Gender Wage Dispari-

ties among the Highly Educated. Journal o

Human Resources, 2008, Vol. 43, No. 3, pp. 630-59.

Blau, Francine D.; and Kahn, Lawrence M. Te U.S

Gender Pay Gap in the 1990s: Slowing Conver-

gence. Industrial and Labor Relations Review,

2006, Vol. 60, No. 1, pp. 45-66.

Bureau o Labor Statistics. Usual Weekly Earnings

o Wage and Salary WorkersSecond Quarter

2011. July 19, 2011. See http://www.bls.gov/

news.release/pd/wkyeng.pd

CONSAD Research Corp. An Analys is o Reasons

or the Disparity in Wages between Men and

Women. January 2009. See www.consad.com/

content/reports/Gender%20Wage%20Gap%20

Final%20Report.pd

Lowen, Aaron; and Sicilian, Paul. Family-Friendly

Fringe Benets and the Gender Wage Gap.

Journal o Labor Research, 2009, Vol. 30, No. 2,

pp. 101-19.

National Bureau o Economic Research. CPS

Merged Outgoing Rotation Groups, 2010

See www.nber.org/data/morg.html

Solberg, Eric; and Laughlin, eresa. Te Gender

Pay Gap, Fringe Benets, and Occupational

Crowding. Industrial and Labor Relations

Review, 1995, Vol. 48, No. 4, pp. 692-708.

th h hw m w m m h bls h c

w m m. F m, h c 2011 h w w 16.5 c. th w h c hw, hw, h h h w w

m m wh h m chcc mch m, 5 c, $35 w.

Median Weely Earnings o Full-time Worers

g e gp t et F r dtt

sourCe: b l sc (bls).

1979 1984 1989 1994 1999 2004 2009

900

800

700

600

500

400

300

200

100

0

40.6

35.6

30.6

25.6

20.6

15.6

10.6

5.6

0.6

Female (left axis) Male (left axis) Earnings Gap (right axis)

DOLLARS G

AP,%

2011 Q2



16/28

wages

Worth Your Weight?Re-examining the Lin

between Obesity and WagesBy Michael . Owyang and E. Katarina Vermann

P a Y c h e c k s

Since 1960, the percentage o Americanadults who are overweight or obese hasrisen rom 46 percent to 74 percent.1 Te

clinically overweight are those with a body

mass index (BMI)2 between 25 and 30; the

clinically obese have a BMI greater than 30.

Not only are heavier individuals at greaterrisk or coronary heart disease, hypertension

and other health problems, but, according to

obesity specialists Rebecca Puhl and Chelsea

Heuer, are highly stigmatized [and

this] weight bias translates into inequities

in employment settings, health-care acili-

ties and educational institutions leaving

[them] vulnerable to social injustice, unair

treatment and impaired quality o lie.3

I such a stigma exists, does this mean that

your weight can aect your wage?

Although wage penalties may exist becauseo stigma, they may also exist because o

dierences in productivity or perceived

productivity. Overweight or obese individu-

als, or example, might receive lower wages

i employers believe that their weight could

aect their health and, thereby, their produc-

tivity. Others contend thatbecause weight

is tied to appearancean overweight/obesity

wage penalty is the ip side o the beauty

premium. Finally, wage dierentials might

reect dierences in socioeconomic status

and education, as the rates o obesity/over-weight are higher among groups with lower

socioeconomic status.

The Obesity Penalty?

Economic studies relating wages and

weight suggest that obese women are less

likely to be employed, relative to normal

weight individuals (BMI o 20 to 25). Among

the employed, heavier women tend to earn

less. Tese penalties have not only increased

over the past ew decades, but continue to

increase as women age.

Te wage penalty or women also varies

by race. Economist John Cawley estimates

that overweight and obese white women

earn 4.5 and 11.9 percent less, respectively,

than normal weight white women. AmongArican-American and Hispanic women, on

the other hand, obese women earn between

6 and 8 percent less than those o the same

race with a BMI under 25; there is no penalty

or black or Hispanic women who are only

overweight. A similar study by economists

Christian Gregory and Christopher Ruhm

ound that the wages o white women peak at

a BMI o 22.5 (well within the normal range),

while wages or black women peak at a BMI

o 26.1 (just above the normal range).

Unlike the ndings or women, whichconsistently indicate the presence o a

weight-wage penalty, the results or men are

0 20 40 60 80

3.0

2.5

2.0

1.5

1.0

% Body Fat (BF)

Body Mass Index (BMI)

INCOME-T

O-

POVERTY

RATIO

BODY SIZE (BMI OR % BF)

Womens Income and Body Size

Figure 1

0 20 40 60 80

3.2

3.0

2.8

2.6

2.4

2.2

% Body Fat (BF)

Body Mass Index (BMI)

INCOME-T

O-

POVERTY

RATIO

BODY SIZE (BMI OR % BF)

Mens Income and Body Size

Figure 2

F h h ch, w 1 c h h m cm w h hh.

(F m, 0.87 w c h h m cm 87 c h hh.) a 1 c h h m cm h hh. (a 1.87 w c h h

m cm 187 c h hh.)

sourCe: n Hh n em s.

more ambiguous. Some studies ound that

underweight and obese white males earn

less than their normal weight counterparts,

while overweight white males earn more.

Not only is the relationship between earn-

ings and weight inconsistent across weight

categories, but inconsistent across races.o illustrate, a 2004 study estimated that

obese Hispanic males earn less than normal

weight Hispanic males, but obese Arican-

American males earn more than normal

weight black males. Other studies ound that

overweight/obese status rarely aects hourly

wages or males but does decrease the likeli-

hood o being employed or all males except

Arican-Americans.4

Is BMI the Wrong Measure?

Te apparent discrepancy between thegenders, however, may be misleading.

Most studies that examine the relationship



17/28

between weight and wages use BMI, which

categorizes individuals based solely on weight

and height. Te medical literature, however,

argues that BMI is problematic because it

is largely arbitrary: It emerged because the

insurance industry wanted a measure or the

mortality risk associated with weight gain. As

such, the normal range or BMI was dened

because o its correlation with the lowest risk

o death (based on lie insurance tables).5 Fur-

ther, BMI is a poor proxy or excess at, as the

index provides no inormation on body shape

and has no way to distinguish body at rom

lean body mass.

In a study last year, economists Joanna

Parks, Aaron Smith and Julian Alston

recommended using a measurement o body

at that takes into account weight, height

and body composition, rather than using

BMI. According to these economists mea-

sures, BMI overestimates the prevalence ounderweight, normal weight and overweight

males, while underestimating the prevalence

o obese males because BMI understates

dierences in body at. Among women, BMI

overestimates the prevalence o underweight

and normal weight women, while underes-

timating the prevalence o overweight and

obese women. As a result, approximately

60 percent o men and 45 percent o women

are misclassied into weight categories when

using BMI as opposed to using percent body

at or percent at-ree mass. Tis ndingindicates that national health statistics are

likely to underestimate the true prevalence o

people who are overweight or obese.

Alternative to BMI Changes Results

Te accompanying gures show the

relationship between an individuals weight

and household income-to-poverty ratio using

data rom the National Health and Nutri-

tion Examination Survey. Te panels depict

how the weight-wage relationship changes

depending on the measure used.Figure 1 shows the relationship between

income-to-poverty ratios and both BMI and

percent body at or women. Tis relation-

ship is more pronounced when using BMI.

Regardless o the measure used, there

remains a negative relationship between body

size and economic status. Since the income-

to-poverty ratio is a proxy or socioeconomic

status, this nding may imply that studies

attributing a wage penalty to a womans body

weight may be picking up on unmeasurable

dierences in social class.

Figure 2 shows a clear, positive relation-

ship between higher body mass and higher

income-to-poverty ratios or men. For body

at, however, the relationship with wages is

much less apparent. Instead, there appears to

be very little association between economic

standing and body at. Regardless, Figure 2

suggests that BMI may overestimate the rela-

tionship between wages and weight, or that

the estimated correlation between wages and

weight may be spurious.

Because o the potential problems with using

BMI as a measure o obesity, a 2010 study by

economists Roy Wada and Erdal ekin used

percent body at and percent at-ree mass

to examine the weight-wage gap. Tis study

ound that increases in body at reduce wages

but that increases in at-ree mass increase

wages. For example, a one kilogram increasein body at was associated with approximately

a 1 percent decrease in wages or all groups

except black males. At the same time, a one

kilogram increase in at-ree mass increases

wages between 1.4 and 1.8 percent or males

and between 0.3 to 0.5 percent or emales.

Summary

Studies that use BMI as a measure o body

at nd inconsistent evidence or an obesity

wage penalty both across genders and races.

However, later studies that examine wagesand weight controlling or body composi-

tion nd that, regardless o gender and race,

excess weight due to at is statistically related

to lower wages, but excess weight due to

muscle is statistically related to higher wages,

regardless o occupation. Tese ndings

indicate that there is, in act, a consistent

wage penalty or body at and a wage pre-

mium or muscle, but discrimination might

not necessarily be the cause. While the

results support the notion that appearance is

an important determinant o wages, the aver-age wage dierentials could exist i employers

believed health and productivity were related

and/or i high body at were taken as a signal

o possible long-term poor health.

Michael . Owyang is an economist andE. Katarina Vermann is a research associate,both at the Federal Reserve Bank o St. Louis.For more on Owyangs work, see http://research.stlouised.org/econ/owyang/


E N D N O E S

1 See www.cdc.gov/NCHS/data/hestat/obesity_

adult_07_08/obesity_adult_07_08.pd2 Calculated as mass / height2. Mass is in kilo-

grams, and height is in meters.3 See Puhl and Heuer.4 Nonetheless, Cawleys ndings are attributable to

unobserved heterogeneity: Lighter white males

have more human capital than heavier white

males, while heavier black males have more

human capital than lighter black males.5 See Parks, Smith and Alston.

R E F E R E N C E S

Burkhauser, Richard V.; and Cawley, John. Beyond

BMI: Te Value o More Accurate Measures o

Fatness and Obesity in Social Science Research,

Journal o Health Economics, March 2008, Vol. 27

No. 2, pp. 519-29.

Cawley, John. Te Impact o Obesity on Wages.

Journal o Human Resources, Spring 2004, Vol. 39

No. 2, pp. 451-74.

Gregory, Christian A.; and Ruhm, Christopher J.

Where Does the Wage Penalty Bite? in Michael

Grossman and Naci H. Mocan, eds., Economic

Aspects o Obesity . National Bureau o Economic

Research. Chicago: University o Chicago Press,

2011.

Han, E.; Norton, E.C.; and Stearns, S.C. Weight

and Wages: Fat Versus Lean Paychecks. Health

Economics, May 2009, Vol. 18, No. 5, pp. 535-48.

Parks, Joanna C.; Smith, Aaron D.; and Alston,

Julian M. Quantiying Obesity in Economic

Research: How Misleading Is the Body Mass

Index? Working Paper No. 61841, Agricultural

and Applied Economics Association, 2010.

Puhl, Rebecca M.; and Heuer, Chelsea A.

Te Stigma o Obesity: A Review and Update.

Obesity Research, 2009, Vol. 15, No. 5, pp. 941-64.

Wada, Roy; and ekin, Erdal. Body Composition

and Wages, Economics and Human Biology, July

2010, Vol. 8, No. 2, pp. 242-54.

t nn n

, n ,

onn nl

o bo n

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non nonl b .


18/28

By Rubn Hernndez-Murillo and Christopher J. Martinek

W o r k i n g i n T h e u. s.

In a previous Regional Economistarticle,we remarked that in order to assess thecosts and benets o immigration (both legal

and illegal) one has to consider the distribu-

tion o skills in the oreign-born population

and compare it with the distribution o skills

among U.S.-born workers.

1

Although aninux o low-skilled immigrants tends to

negatively aect the wages o similarly skilled

U.S.-born workers, this inux could increase

the productivity o medium-skilled workers,

who comprise the majority o U.S.-born work-

ers, i their skills complement each others.

Not only is the distribution o skills among

the oreign-born population widely dierent

rom that o their U.S.-born counterparts,

but the choices these immigrants make when

deciding where to live in the U.S. also dier

considerably rom those choices made by

natives. Furthermore, or similar levels oskill or education, immigrant workers tend

to choose dierent occupations than native

workers do.

Identiying the dierences in the composi-

regional economist - fall 2011

Documents