Brookings: Experts - William T. Dickens

Has the Recession Increased the NAIRU?

William T. Dickens — Wed, 29 Jun 2011 00:00:00 -0400

Abstract

The increase in job vacancies over the last two years has not been accompanied by a decline in unemployment. When this has happened in the past it has coincided with an increase in the NAIRU. Despite some qualifications as to why it might not be appropriate to view the recent increase as indicating such a shift, I use updated data to estimate the model developed in my 2009 paper that links movements in the Beveridge curve (the trade-off between job vacancies and unemployment) and the NAIRU. That exercise suggests that the NAIRU has risen from about 5% before the most recent recession to 5.8% in the first quarter of 2011.

I then consider possible explanations for this outward shift including the persistence of high rates of long-term unemployment, extended unemployment benefits, a mismatch of skills between the unemployed and available jobs, and geographic mismatch exacerbated by problems in the housing market. I find little evidence to support the view that an increase in the level of long-term unemployment in the U.S. will lead to an increase in the NAIRU, but no strong evidence against the hypothesis either. A review of the evidence on the impact of extended unemployment benefits suggests that they probably have played a significant role in increasing the NAIRU, and the best estimates could explain the entire increase. Analysis of data on unemployment rates and vacancy rates by industry suggest that it is unlikely that skills mismatch has played an important role in the increase in the NAIRU. Similar evidence on geographic mismatch also calls that explanation into question. A number of recent papers have examined the extent to which problems in the housing market may be responsible for very low labor mobility that might be causing geographic mismatch. Most of the evidence suggests that this is not currently a problem though it is possible it could become more of a problem when the economy begins to pick-up.

I conclude that while the NAIRU has probably increased, that is unlikely to be an important consideration for monetary or fiscal policy for some time. I also comment on the role that aggregate demand management and monetary policy could play in reducing some of the problems that might be causing the increase in the NAIRU.

Introduction

Starting with Blanchard and Summers (1987) it has been observed that there is a tendency for unemployment to remain high in some countries after a recession. In a series of papers, Lawrence Ball (1997, 1999, 2009a&b) has suggested that in most OECD countries the NAIRU increases after each recession. An exception, at least in the past, has been the United States. Here the unemployment rate has returned to levels that prevailed before recessions except during the period of rising unemployment in the 1970s.

Ball has suggested that the reason for U.S. exceptionalism in this matter is the aggressive counter cyclical policy that the Federal Reserve has pursued to fulfill its dual mandate of stable prices and full employment. Ball also points to several cases where countries other than the U.S. successfully lowered high unemployment rates with aggressive monetary policy at the expense of small increases in inflation.

Ball has proposed several explanations for this phenomenon, but here I focus on those that relate to the efficiency of the labor market matching function. In particular, Ball argues that the long-term unemployed may put less downward pressure on wages than those unemployed for a shorter period either because their search intensity decreases or because they are viewed as less able by employers.

Below I argue that there is already evidence of a decrease in the efficiency of matching in the U.S. and that this has led to a moderate increase in the NAIRU. I will review a range of evidence on the hypothesis that prolonged periods of high long-term unemployment lead to an increase in the NAIRU and conclude that there is no strong evidence for this mechanism, but that the conjecture that it is at least a partial cause of the decline in labor market efficiency cannot be dismissed.

Having not found a complete and convincing explanation for the decline in efficiency I turn to several other possible explanations to see what they might contribute. Extended unemployment benefits likely explain a significant part of the change and possibly the entire change. I argue that structural mismatch of the skills of the unemployed and the skill demands of available jobs probably has not contributed importantly to the growth of unemployment. Evidence on geographic mismatch does not suggest a role for it either, though it is possible that housing market problems could prevent labor mobility and increase the NAIRU in the future. I conclude with a discussion of the policy implications of the findings.

Downloads

Download the Full Paper

Authors

William T. Dickens

Publication: Northeastern University and the Brookings Institution

Yes, We Can Reduce the Unemployment Rate

William T. Dickens — Wed, 29 Jun 2011 00:00:00 -0400

Recommendations: Analysis of data on vacancies and unemployment, as well as data on geographic and industry skill mismatch finds no evidence that unemployment is mainly due to a mismatch of jobs and workers. Instead, an increase in demand for goods and services would almost certainly bring down the unemployment rate. This could be accomplished by more aggressive fiscal and monetary policy. Fiscal retrenchment in the short run is likely to increase unemployment even though long term structural deficits must be dealt with in a credible way.

"Mr. Plosser's answer is unequivocal: This mess was caused by over-investment in housing, and bringing down unemployment will be a gradual process. 'You can't change the carpenter into a nurse easily, and you can't change the mortgage broker into a computer expert in a manufacturing plant very easily. Eventually that stuff will sort itself out. People will be retrained and they'll find jobs in other industries. But monetary policy can't retrain people. Monetary policy can't fix those problems.'"
—Mary O'Grady, The Wall Street Journal
February 14, 2011

"Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers. Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot.... Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy."
—Narayana Kocherlakota
Speech at Northern Michigan University
Marquette, Michigan
August 17, 2010

Charles Plosser and Narayana Kocherlakota are Presidents of the Philadelphia and Minnesota Federal Reserve Banks respectively. If they are right then there is certainly no point in continued efforts by the Federal Reserve to increase demand for goods and services by bring down long term interest rates or for the congress to consider additional fiscal stimulus. However, I have recently examined a wide range of data, including that on which President Kocherlakota based his conclusion, and I believe a very different conclusion is warranted. While it is likely that there has been a decline in the efficiency with which the labor market matches jobs and workers, that decline in efficiency explains only a small fraction of the huge increase in unemployment since the onset of our most recent recession. Further, the most likely explanation for that decline in efficiency is the extension of unemployment benefits to the long-term unemployed. What doesn’t seem to have played much, if any, role in increasing unemployment is either the geographic or industrial mismatch of workers. Demand for workers is depressed across the board. While there may be very small geographic or occupational niches where workers are in short supply, such bottlenecks always exist in the labor market and data suggest that such bottlenecks are actually at a low ebb.

Downloads

Download the Paper

Authors

William T. Dickens

Publication: Northeastern University and the Brookings Institution

Image Source: © Brian Snyder / Reuters

A New Approach to Estimating the Natural Rate of Unemployment

William T. Dickens — Tue, 28 Jul 2009 17:05:57 -0400

INTRODUCTION

The non-accelerating inflation rate of unemployment (NAIRU) is frequently employed in fiscal and monetary policy deliberations. The U.S. Congressional Budget Office uses estimates of the NAIRU to compute potential GDP, that in turn is used to make budget projections that affect decisions about federal spending and taxation. Central banks consider estimates of the NAIRU to determine the likely course of inflation and what actions they should take to preserve price stability. A problem with the use of the NAIRU in policy formation is that it is thought to change over time (Ball and Mankiw 2002; Cohen, Dickens, and Posen 2001; Stock 2001; Gordon 1997, 1998). But estimates of the NAIRU and its time variation are remarkably imprecise and are far from robust (Staiger, Stock, and Watson 1997, 2001; Stock 2001).

NAIRU estimates are obtained from estimates of the Phillips curve— the relationship between the inflation rate, on the one hand, and the unemployment rate, measures of inflationary expectations, and variables representing supply shocks on the other. Typically, inflationary expectations are proxied with several lags of inflation and the unemployment rate is entered with lags as well. The NAIRU is recovered as the constant in the regression divided by the coefficient on unemployment (or the sum of the coefficient on unemployment and its lags).

The notion that the NAIRU might vary over time goes back at least to Perry (1970), who suggested that changes in the demographic composition of the labor force would change the NAIRU. He adjusted the unemployment rate to account for this. By 1990 several authors, including Gordon (1990) and Abraham (1987), had suggested that the NAIRU was probably lower in the 1960s than in the 1970s and 1980s. This adjustment was initially accommodated by adding dummy variables or splines for certain periods to the Phillips curve regression. However, when it began to appear that the U.S. NAIRU was coming down in the 1990s, new methods were developed to track its changes. Staiger, Stock, and Watson (1997), Gordon (1997, 1998) and Stock and Watson (1999) applied time-varying coefficient models and structural break models to NAIRU estimation, and typically found evidence that it rose in the late 1960s or early 1970s and declined in the 1990s.1 However, the timing and the magnitudes of the estimated changes differed markedly depending on the specification used. Furthermore, confidence bounds on the estimated NAIRUs were so large that the estimates had little value for policy.

This paper presents a new approach to estimating time variation in the NAIRU. A major problem with Phillips curve-based estimates is that the complicated relationship between inflation, its own lags, supply shocks, and unemployment and its lags makes it possible to explain any particular incidence of high or low inflation a number of different ways. This problem is the root cause of both the lack of robust results and the large confidence intervals around NAIRU estimates derived from Phillips curve estimates. This paper explores an alternative source of information about time variation in the NAIRU. To the extent that such changes are due to changes in the efficiency of the labor market, these changes are reflected not just in the relationship between inflation and unemployment, but also in the relationship between unemployment and job vacancies. That relationship is much simpler and consequently much easier to model in a robust fashion. Combined estimates of the Phillips curve and Beveridge curve—the relationship between unemployment and vacancies—yield remarkably consistent estimates of the timing of changes in the NAIRU. The next section provides a brief introduction to the literature on the Beveridge curve and on how it has shifted over time. It argues that because the Beveridge curve is much simpler and potentially better fitting than the Phillips curve, it provides a better basis for discerning shifts in the efficiency of the labor market’s functioning. These shifts appear to be quite large. The second section develops a theory linking shifts in the Beveridge curve to shifts in the NAIRU. The third section presents estimates of the Beveridge curve model developed in the second section. These estimates turn out to be very robust and motivate the model developed in the fourth section.

The fourth section presents estimates of a linearized version of the model using a Kalman filter. The filtered series is essentially a weighted average of the residuals of the Beveridge and Phillips curves that has been scaled to satisfy an identifying constraint—this constraint is that the coefficient on the filtered variable must be the same as minus the coefficient on the unemployment rate in the Phillips curve. As might be expected, given how precisely the Beveridge curve is estimated, the filter puts nearly all the weight on the Beveridge curve residuals. Estimates of a restricted version of the model suggest that the information from the Beveridge curve adds significantly to the explanatory power of the Phillips curve.

The Beveridge curve and Phillips curve NAIRUs look fairly similar, a result which supports the theory behind both curves. Confidence intervals that account for both forecast and parametric uncertainty are about 40 percent larger for Phillips curve NAIRU series than for series derived from the combined Beveridge curve-Phillips curve model. While estimates of the magnitude of the fluctuations in the NAIRU based on the joint Beveridge curve-Phillips curve model are still fairly uncertain, there is little uncertainty about the timing of the fluctuations.

Downloads

Download Paper

Authors

William T. Dickens

Publication: Federal Reserve Bank of Boston

Psychometrics Society Keynote on Modeling in Psychology

William T. Dickens — Tue, 21 Jul 2009 00:00:00 -0400

In July 2009 William Dickens was invited to give the opening keynote lecture to the International Meetings of the Psychometrics Society. He spoke on what psychologists could learn about modeling psychological phenomena from the way economists use models and illustrated it with his own work on cognitive ability.

View lecture slides»

Downloads

Presentation Slides

Authors

William T. Dickens

Publication: Psychometrics Society

The Fiscal Effects of Investing in High-Quality Preschool Programs

Charles Baschnagel and William T. Dickens — Tue, 14 Apr 2009 12:00:00 -0400

SUMMARY

Randomized treatment-control experiments suggest large returns to investments in prekindergarten education. Several studies consider the social benefits of such investments, but none have considered the full potential gains to government budgets. We embed estimates of the effects of two model programs in a growth model of the U.S. economy to judge the impact they would have on federal, state and local government budgets. Assuming a 3 percent discount rate we find that both programs would pay back in reduced costs and increased revenues in excess of three-fourths of their costs within a seventy-five year budget window. Both programs would eventually reap a positive return for government budgets if policymakers were sufficiently patient.

Investing in Children

Children living in families with low incomes and those with poorly educated parents are much more likely than other children to grow up to be adults with less education, lower incomes, poorer health, and shorter lives. There have been many attempts to break this cycle of poverty by enriching the environment in which disadvantaged children grow up and to better prepare them to enter school. In order to decide if these programs actually deliver the results they are aiming for, random assignment experimental evaluations with long time horizons must be conducted. Unfortunately, relatively few of these “gold standard” evaluations have been carried out. However, some programs — notably Perry Preschool and the Abecedarian Project — have been shown to have positive effects on later life outcomes in such studies.

Other studies have shown that the social benefits of these programs can substantially outweigh the social costs suggesting that they could be excellent social investments. Most of the benefits of these programs accrue to the participants, mainly in the form of higher income, which is due in large part to their obtaining more education. On the other hand, most of the costs fall on taxpayers when pre-kindergarten programs are implemented as public programs. Taxpayers, however, also reap some of the benefits. If program participants earn higher incomes, they will pay more taxes and be less likely to rely on government transfers. If they are less likely to require special education or to repeat grades, they will cost less to educate. This study attempts to calculate the fraction of the total costs to taxpayers that would likely be recovered if large scale versions of two early childhood programs were to be instituted. We use a simulation model of the U.S. economy to estimate the net effects of investing in pre-kindergarten programs on government budgets.

Ideally, governments would undertake all projects for which net social benefits are positive. However, if a program which has been shown to have positive net social benefits also pays for a large fraction of its own costs with revenue increases and savings, it then becomes more attractive than other programs that produce the same level of benefits but without the fiscal dividend. More such programs could be undertaken within a limited budget. Thus, we believe that the estimates we provide here are a useful supplement to the more traditional benefit-cost analysis of these programs.

Downloads

Download

Authors

Charles Baschnagel
William T. Dickens

What is g?

William T. Dickens — Thu, 03 May 2007 00:00:00 -0400

Large secular gains in cognitive ability (the Flynn Effect) show that large, environmentally induced changes in measured cognitive ability are possible, but several studies have suggested that secular gains are not gains in general cognitive ability because the gains across different tests are not proportional to the degree to which each test reflects general cognitive ability.

Many have argued that secular gains are therefore not gains in real cognitive ability, but represent only changing measurement error. In his new paper which Dickens presented at the 2007 meetings of the American Education Research Association he extends the model of a single cognitive ability presented by Dickens and Flynn (2001) to multiple abilities. It shows that such a model can account for all the important facts about general cognitive ability without postulating any common underlying physiological cause for different mental abilities. A general intelligence factor (the tendency for someone who is good at any cognitive skill to be good at the full range of cognitive skills) arises in the model because people who are better at any cognitive skill are more likely to end up in environments that cause them to develop all skills. Scores on the resulting general ability factor can be highly heritable even while they are potentially subject to considerable environmental influence. Loadings of subtest scores on the general ability factor can be positively correlated with subtest heritabilities. In the model, discrimination against a social group in access to cognitively demanding environments can produce subtest score differences from other groups that are strongly correlated with both the g loadings and heritabilities of those subtests. Despite this, there is no reason to expect that meaningful secular gains should be correlated with g loadings across subtests. Thus there is no reason to conclude that secular gains do not represent real increases in cognitive capabilities.

View full paper (pdf)
View presentation (pdf)

Downloads

Download

Authors

William T. Dickens

Cognitive Ability and IQ Gains

William T. Dickens — Tue, 01 May 2007 00:00:00 -0400

In 2001 William Dickens and James Flynn proposed a model of cognitive ability that explains how large IQ gains, such as those observed in the United States and other countries over the 20th century, are possible despite the substantial roll played by genes in explaining differences among people within the same social group.

That model predicts that improvements in the environments of African Americans should have resulted in a decline in the white-black IQ gap and in 2006 Dickens and Flynn presented evidence that such a decline has indeed taken place. In an article forthcoming in The New Palgrave Dictionary of Economics, Dickens explains his views on cognitive ability. Most recently Dickens presented a paper on a new theory of general intelligence at the April 2007 meetings of the American Education Research Association meetings in Chicago.

Downloads

Download

Authors

William T. Dickens

Publication: IQ Series

The Interaction of Labor Markets and Inflation

Thu, 22 Feb 2007 12:00:00 -0500

The adoption of explicit or implicit inflation targets by many central banks, and the low stable rates of inflation that have ensued, raise the question of how inflation affects market efficiency. The goal of the International Wage Flexibility Project (IWFP) —a consortium of over forty researchers with access to micro level earnings data for 16 countries—is to provide microeconomic evidence on the costs and benefits of inflation in the labor market. The results are intended to inform researchers as well as monetary and regulatory policymakers who are interested in labor markets or the impact of inflation. We study three market imperfections that may cause the rate of inflation to affect labor market efficiency.

The International Wage Flexibility Project

William Dickens and Erica Groshen are co-directors of the International Wage Flexibility Project — a multi-country study using data on individual wages and incomes to study the effects of inflation on wage setting and to determine the nature, extent, causes and consequences of several kinds of wage rigidity. The aim of the project is to improve monetary policy and the regulation of labor market institutions in all countries.

The project has received considerable support from the European Central Bank (www.ecb.int), the IZA (www.IZA.org), the Volkswagen Foundation (www.volkswagen-stiftung.de), and the New York Federal Reserve Bank (www.ny.frb.org). The project is being conducted by teams of researchers in 14 countries with results from the individual countries being aggregated for analysis by researchers at the New York Federal Reserve (Erica Groshen), the European Central Bank (Julian Messina, Jarkko Turunen, and Melanie Ward-Warmedinger), the Kansas City Federal Reserve (Mark Schweitzer), the University of Oslo (Steinar Holden), the University of Zurich (Lorenz Goette), and the Brookings Institution (William Dickens).

The initial findings of the International Wage Flexibility Project were published in How Wages Change: Results from the International Wage Flexibility Project which was published in the Journal of Economic Perspectives Spring 2007 issue. More recent findings are described in “The Interaction of Labor Markets and Inflation: Micro Evidence from the International Wage Flexibility Project” The methodology of the project is described in "Estimating Wage Rigidity for the International Wage Flexibility Project." The IWFP team has now begun work on a book on the results of the project.

Downloads

Download

Authors

William T. Dickens
Lorenz Goette
Erica Groshen
Steinar Holden
Julian Messina
Mark Schweitzer
Jarkko Turunen
Melanie Ward

Black Americans Reduce the Racial IQ Gap: Evidence from Standardization Samples

James R. Flynn and William T. Dickens — Sun, 01 Oct 2006 00:00:00 -0400

Abstract

It is often asserted that Black Americans have made no IQ gains on White Americans. Until recently, there have been no adequate data to measure trends in Black IQ. We analyzed data from nine standardization samples for four major tests of cognitive ability. These data suggest that Blacks gained 4 to 7 IQ points on non-Hispanic Whites between 1972 and 2002. Gains have been fairly uniform across the entire range of Black cognitive ability.

Pre-publication materials:

Published version available to members of the Association for Psychological Science.

Downloads

Download

Authors

James R. Flynn
William T. Dickens

Publication: Psychological Science

Puerto Rico's Economic Challenge

Thu, 25 May 2006 09:00:00 -0400

Event Information

May 25, 2006
9:00 AM - 12:00 PM EDT

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

Puerto Rico presents a puzzling economic situation. As a territory of the United States, it has many of the institutions that economists judge crucial to growth. It is one of the world's most open economies, with free mobility of goods, services, capital, and labor to the large, prosperous U.S. market; and firms and individuals and firms who are resident in Puerto Rico are exempt from federal taxes. One might expect these conditions to pave the way for rapid economic development in Puerto Rico, with living standards converging steadily toward those enjoyed in the rest of the nation. However, since the mid 1970s, that growth has stalled. Puerto Rico's per capita income is only about half that of the poorest U.S. state and a majority of its residents live below the U.S. poverty line.

What went wrong? Motivated by Puerto Rico's economic dilemmas, researchers from Puerto Rico and the mainland collaborated on an extensive project led by the Center for the New Economy (CNE) and the Brookings Institution. The resulting book examines the island's low-employment rates, comparatively small private sector, trade performance, and the effectiveness of its educational, financial and fiscal systems. Chapters also focus on the effects of key U.S. policies on the island, particularly in the areas of taxation and social transfers.

To discuss the book and recent developments in Puerto Rico, Susan Collins, Barry Bosworth and William Dickens, all Brookings senior fellows, were joined by Miguel Soto-Class from the CNE; Maria Enchautegui from the University of Puerto Rico; Steven Davis from the University of Chicago and the American Enterprise Institute for Public Policy Research (AEI); and Francisco Uriarte also of CNE.

Panel One: Economic Growth in Puerto Rico

Moderator:
Miguel Soto-Class
Center for the New Economy

Presenter:
Susan Collins
The Brookings Institution & Georgetown University

Panel Two: Why is Employment So Low?

Moderator:
William Dickens
The Brookings Institution

Panelists:
Maria Enchautegui, University of Puerto Rico
Steven Davis, University of Chicago & AEI

Panel Three: Options for Restoring Growth

Moderator:
Francisco Uriarte
Center for the New Economy

Presenter:
Barry Bosworth
The Brookings Institution

Transcript

Transcript (.pdf)

Event Materials

The Effects of Investing in Early Education on Economic Growth

Isabel V. Sawhill, Jeffrey Tebbs and William T. Dickens — Sun, 30 Apr 2006 00:00:00 -0400

Abstract

Many in Congress and the administration have called for new investments in education in order to make the United States more competitive, with President Bush stressing the importance of education in preparing young Americans to "fill the jobs of the 21st century." Yet advocates of early childhood education have only recently stressed the economic benefits of preschool programs, and it has been difficult to win support for these short-term investments given the long-term nature of the benefits to the economy.

This policy brief analyzes the impact of a high-quality universal preschool policy on economic growth, concluding that such a policy could add $2 trillion to annual U.S. GDP by 2080. By 2080, a national program would cost the federal government approximately $59 billion, but generate enough additional growth in federal revenue to cover the costs of the program several times over.

Policy Brief # 153

Economists have long believed that investments in education, or "human capital," are an important source of economic growth. Over the last 40 years output has risen about 3.5 percent a year. Growth in the productivity of labor, the major driver of increases in wages and standards of living, has measured about 2.4 percent per year. The contribution of education to labor productivity growth is estimated in different studies to be between 13 and 30 percent of the total increase. Whatever the contribution of education to growth in the past, investments in human capital may rise in importance relative to investments in other forms of capital as we transition to a post-industrial, knowledge-based economy.

Why might a more highly-educated work force increase economic growth? A more educated labor force is more mobile and adaptable, can learn new tasks and new skills more easily, can use a wider range of technologies and sophisticated equipment (including newly emerging ones), and is more creative in thinking about how to improve the management of work. All of these attributes not only make a more highly skilled worker more productive than a less skilled one but also enable employers to organize their work places differently and adjust better to changes necessitated by competition-by technical advances or by changes in consumer demand.

Just as a firm with better educated workers can perform better in these dimensions, so too can an economy with a better educated workforce. Skills beget more skills and new ways of doing business, workers learn from one another, and firms adapt their technology and their use of capital to the skills of the available work force. The benefits of having a more educated work force accrue to everyone, not just to the organization where these individuals happen to work. Further, these kinds of indirect (or spillover) effects for the firm or the economy as a whole may be especially important in an increasingly competitive global marketplace. Imagine an economy lacking in people able to read directions, use a sophisticated copier or a computer, or understand prevailing norms of behavior. Even if a single organization in that economy were able to find or import such skills, other organizations would not be able to invest in certain kinds of equipment or certain kinds of businesses with any assurance that it could make the investment profitable. Beyond that, a more educated work force may produce a less crime-ridden and healthier environment with better functioning civil institutions and all the benefits that flow to the business sector from that environment.

Past Work on Education and Growth

In 1957, Nobel Laureate Robert Solow described the growth of national income as having three sources: increases in the stock of physical capital (machines and buildings that are used to produce goods and services), increases in the size of the labor force, and a residual representing all other factors. This residual contributed considerably more to per capita growth than the increase in the capital stock. Solow dubbed the residual "technical progress" and noted that increasing levels of education were one of the factors that contributed to its growth. Using the same basic approach as Solow, but explicitly accounting for the role of education, Edward Denison estimated that between 1929 and 1982, increasing levels of education were the source of 16 percent of the growth of total potential output in the nonresidential business sector (and 30 percent of the growth in the productivity of people employed in that sector). A more recent study by Dale Jorgenson and Kevin Stiroh puts the contribution of education to economic growth at 8.7 percent of total growth over the period 1959 to 1998 and 13 percent of growth in output per worker.

Over the last two decades more attention has been paid to the theory of how education might affect economic growth and this work has implications for how we might model the impact of increased educational attainment. The "neoclassical" or "exogenous growth" studies described above assume that the immediate impact of increasing the amount of education per worker by 10 percent would be to increase GDP by only about 4 to 5 percent. Also, in the type of model used in those studies an increase in the rate of investment leads to an increase in the level of GDP, but in the long run has no effect on the rate of growth of GDP. More recent research using models where growth is endogenous suggests that both the direct and indirect effects of education on growth could be substantially larger. In some of these models the direct impact of a 10 percent increase in the amount of education that people get could be as much as 7 or 8 percent, and an increase in the rate of investment in education could produce a permanent increase in the rate of growth.

Prominent economists, including two recent chairmen of the President's Council of Economic Advisers, hold sharply divergent views on the validity of these different models of economic growth. In order to proceed with our analysis without wading into this largely unsettled debate, we develop a single model that allows a broad range of assumptions about the importance of education for economic growth.

The Effects of Preschool Enrollment on Later Educational Attainment

We first estimate the effects of a specific preschool policy intervention on educational attainment and then analyze the effects of that additional education on economic growth relative to the projected growth path in the absence of the policy. In the particular simulation reported in this policy brief, we analyze the growth effects expected from a high-quality, national preschool program for all three- and four-year-old children. The best evidence about the effects of such an intervention on educational attainment comes from a set of small-scale experimental programs that featured random assignment and longitudinal evaluation of study participants. For this simulation, we use results from studies of the Perry Preschool Program, which delivered a high-quality program to a small group of disadvantaged children in Ypsilanti, Michigan in the 1960s, to determine the magnitude of the effect of high-quality preschool. We then adjust these results for the probable attenuation associated with delivering the program to a much broader and less disadvantaged group of children.

The Perry Preschool program provided low-income three- and four-year-old children with center-based care, two-and-a-half hours per day, five days per week for thirty weeks each year. The center-based care was supplemented on a weekly basis with one-and-a-half hour home visits by the child's instructor. The Perry program was characterized by high instructor quality, as well as remarkably low student-teacher ratios. Study participants were selected on the basis of their low socioeconomic status (SES). In order to assess the effects of the program, program participants were randomly selected from a larger group of qualified children and the experiences of both those who took part in the program and those who did not were monitored on a periodic basis until the present-day, with study participants most recently surveyed at the age of forty.

At age twenty-seven, participants in the program were found to have levels of educational attainment 0.9 years greater than non-participants. We utilize this finding as the primary input to our economic growth model. It's worth noting, however, that this difference in educational attainment likely understates the productivity improvements of program children, who also experienced gains in non-cognitive characteristics, including persistence and diligence. Also these narrow economic benefits were supplemented by numerous other benefits, including reduced rates of teenage pregnancy and dramatically lower rates of criminal activity relative to children who did not receive the program.

Projecting the effects of implementing a small scale program like Perry on a national level requires a number of assumptions in addition to the impact of the program on those who take part. First, a universal preschool program, if not compulsory, will not serve the full set of eligible children. Second, many of the children potentially served by this new policy initiative may already be enrolled in existing preschool programs, whereas most of children in the no-program group evaluated in the Perry study did not receive any early childhood education. Presumably, the impact of the program will be smaller for these children. Third, universal preschool programs will serve children that are less disadvantaged than those in the Perry Preschool experiment. It is not clear whether students with higher SES will experience comparable gains in educational attainment. Finally, preschool administrators may experience considerable difficulty in maintaining an equally high level of program quality in a program enrolling millions, rather than dozens, of children.

Based on experiences in Oklahoma and Georgia, scholars at RAND estimated that participation in a high-quality, voluntary, universal public preschool program would reach 70 percent of eligible children. Currently, 52 percent of three- and four-year-olds are already enrolled in preschool of some kind. Of those children who are already enrolled in preschool, roughly half are enrolled in public programs and half are enrolled in private programs. We assume that out of every 100 children, 70 will enroll in the proposed Perry-type program. These 70 children will be comprised of all of the children previously enrolled in public programs, approximately half of the children previously enrolled in private programs, and 60 percent of the children previously not enrolled in any preschool program.

We assume that children who would not have attended any preschool in the absence of this universal program now reap 100 percent of the benefits estimated for Perry (the full 0.9 year gain in educational attainment). We also assume that children who attended public preschool programs in the absence of this policy initiative will receive 50 percent of the effect, as the new initiative should be higher in quality than the average public program. For example, only 20 of the 38 states that provide any public preschool require lead teachers to hold a baccalaureate degree, whereas our proposed program requires all lead teachers in all states to possess such credentials. Finally, we assume that children previously enrolled in private preschool programs receive no additional educational benefit.

With regard to the possibility of differential program effects on children from more and less advantaged households, we turn to evidence from Oklahoma's universal preschool program, which has recently been subjected to a quasi-experimental evaluation. That study, by William T. Gormley Jr., and others, found strong (and nearly comparable) gains across all income classes (though the children studied were still very young). These results indicate that children from both low and high income families may receive roughly comparable educational gains from participation in high-quality preschool programs. Similar findings have recently been reported in a study by W. Steven Barnett, Cynthia Lamy, and Kwanghee Jung at the National Institute for Early Education Research that evaluated preschool programs in Michigan, New Jersey, Oklahoma, South Carolina, and West Virginia.

In light of this evidence, we did not believe that it was necessary to reduce the effects further. Moreover, since nearly 20 percent of children under age six live in families below the poverty line, many of the remaining children who newly enroll in the universal program could conservatively be categorized as "at risk." Under these assumptions, we calculate that the average increase in educational attainment for all children due to the preschool program will be 0.36 years.

How Educational Attainment Affects Economic Growth

The model tracks the number of years of education attained by each birth cohort and increases it for cohorts that received the preschool program. Take as an example a preschool program that covers half the population and causes people who attend to get an additional half year of education. This would cause an increase of a quarter of a year in the education of those in the first cohort to receive the program. However, for the first thirteen to fourteen years the program has no effect on growth as the first cohort of students who received the program are moving through elementary and secondary school. Eventually, there is an increase in the number of years of education these students obtain, which has two effects. First, since they are staying in school longer this reduces the size of the labor force and has a temporarily negative impact on output. However, once these students graduate their additional schooling enhances their productivity, yielding a positive impact on output. As time passes, and more students who have been in the preschool program graduate, the impact of the program on the size of the labor force remains roughly the same but the impact on the productivity of the workforce grows as larger fractions of the population receive the extra education. The direct effects continue to rise until the first cohort to receive the preschool education reaches retirement age.

These direct effects of increased education on output are augmented by the fact that some of the increased income generated by increased growth is reinvested in both physical and human capital. These dynamic feedback effects on physical and human capital accumulation go on year after year with the persistence of the growth effects depending on the assumptions made about the immediate impact of human capital on GDP.

Results

As discussed previously, the current state of macroeconomic research does not allow us to pin down a single value for the impact of education on GDP. Instead we test three different values spanning what we consider to be the plausible range. We label these "High Estimate," "Low Estimate," and "Preferred Estimate." Our preferred estimate is not an intermediate value, but one conforming to the assumptions made in the particular growth model that we find most compelling.

Figure 1 displays the year-by-year predictions for all three impact assumptions relative to what economic growth would have been without the preschool program over a 75-year time horizon. The baseline per capita growth assumptions are drawn from the 75-year projections of the Social Security Trustees. To estimate growth effects we must make numerous assumptions about the growth process. To choose our preferred assumptions, we turn mainly to historical averages. In particular, we rely heavily upon data from the National Income and Product Accounts of the Bureau of Economic Analysis and the March Current Population Surveys reported by the Bureau of Labor Statistics.

The first effect of the policy initiative is to reduce the supply of labor when the first participants reach the age at which they would normally enter the labor force but instead extend the time they spend in school. This effect begins in 2025. However, when they enter the work force, they are more productive due to the additional education and that has a positive effect on output. By 2046, under all three assumptions, the positive effects start to outweigh the negative effects. At the high end, the effects turn positive as early as 2038. From here, the effects rapidly increase in magnitude, as additional treated cohorts enter the labor force and increased economic growth starts to result in positive dynamic feedbacks.

Table 1 reports estimates of the effect of the program on GDP for the 45-, 60-, and 75-year time horizon. Under the preferred estimate, by 2080, GDP increases by 3.50 percent, or 2,034 billion 2005 dollars, producing an extra $7,699 per capita.

These findings are robust to a wide range of reasonable values for key assumptions. While we conduct a full battery of sensitivity analyses, we find that the conclusions of the model are most heavily influenced by two key factors. First, the model is keenly sensitive to assumptions about the program's take-up rate and the additional benefits received by those already receiving some form of preschool education, as well as any attenuation of effects associated with moving from a small and targeted program to one that serves all three- and four-year olds.

In addition, the results are also highly sensitive to the expected rate of return on education. It is possible that we have overestimated this return if employers not only value the knowledge people obtain in school, but also utilize educational credentials to identify individuals with high innate levels of ability. Concurrently, however, it is possible that we have underestimated the return to an investment in preschool in that we have not included the productivity gains for those Perry Preschool participants whose educational attainment was unaffected, but who nonetheless were more successful in the labor market as measured by their higher earnings.

Conclusion

The model predicts substantial gains in GDP, and in the stocks of physical and human capital, across a wide range of assumptions about the growth process. With our preferred assumptions, we predict an increase in GDP in 2080 of over $2 trillion (2005 dollars)-an increase of about 3.5 percent. Further, we must emphasize that these growth effects are all in addition to the well documented social benefits of early education programs.

To put these gains in perspective consider that federal revenue is likely to increase by about 20 percent of the total increase in GDP, or by about $400 billion (.20 x $2 trillion). We estimate that in 2080 the net cost of the program to the federal government will be $59 billion for a net fiscal surplus of $341 billion. At the same time, there are substantial costs that must be paid in the first few decades of the program and in this first report on our project, we have not attempted to determine the net benefits from the additional growth caused by this policy initiative. However, such estimates, along with other extensions of the model, are feasible. If we are underinvesting in education for some fraction of our population now, additional net benefits could be achieved by increasing the amount of education people get. This is more likely to be the case to the extent that spillover (or external) effects of education are important and to the extent that individuals fail, for various reasons (lack of financial liquidity, short-sightedness), to make investments for their children whose benefits accrue over the longer-run.

Because most of these benefits are longer-term while the costs of mounting the programs are more immediate, the political system tends to be biased against making such investments. However, any business that operated in this way would likely fail to succeed. A similarly dim prospect may be in store for a country that fails to take advantage of such solid investment opportunities.

Table 1. Effects of Universal Preschool for Three- and Four-Year-Olds On Gross Domestic Product (GDP)

Low Estimate
	% Increase in GDP	Dollar Increase in GDP (2005 dollars)
2050	0.20%	$62 billion
2065	0.92%	$391 billion
2080	1.34%	$778 billion

Preferred Estimate
	% Increase in GDP	Dollar Increase in GDP (2005 dollars)
2050	0.88%	$270 billion
2065	2.34%	$988 billion
2080	3.50%	$2,034 billion

High Estimate
	% Increase in GDP	Dollar Increase in GDP (2005 dollars)
2050	1.02%	$314 billion
2065	2.65%	$1,123 billion
2080	4.02%	$2,340 billion

Figure 1. Effects of Universal Preschool for Three- and Four-Year-Olds On Gross Domestic Product (GDP)

This work was funded by the National Institute for Early Education Research with a grant from The Pew Charitable Trusts – Advancing Quality Pre-Kindergarten for All.

See related paper: The Effects of Investing in Early Education on Economic Growth

Downloads

Download

Authors

Preparing America to Compete Globally: A Forum on Offshoring

Wed, 03 Mar 2004 13:15:00 -0500

Event Information

March 3, 2004
1:15 PM - 3:00 PM EST

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue, N.W.
Washington, DC 20036

Concerns about growing numbers of American service and manufacturing jobs moving overseas have become a central theme in the political and economic debates over the jobless recovery, debates that have intensified as the 2004 elections approach.

Senator Max Baucus (D-Mont.), the senior Democrat on the Senate Finance Committee, will appear at a Brookings briefing on the issue to present a set of policy proposals that aim to keep and create jobs in America. Sen. Baucus will be joined by a panel of experts that will assess his proposals as well as offer their own diverse perspectives on the offshoring issue.

Transcript

Transcript (.pdf)

Event Materials

20040303

Participants

Moderator

Ron Nessen

Journalist in Residence, Brookings

Panelists

E.J. Dionne, Jr.

Senior Fellow, Governance Studies, Brookings; Columnist, Washington Post

Harris Miller

President, Information Technology Association of America

Jared Bernstein

Senior Economist, Economic Policy Institute

Senator Max Baucus (D-Mont.)

Instinct and Choice: A Framework for Analysis

Jessica L. Cohen and William T. Dickens — Thu, 13 Jun 2002 00:00:00 -0400

Later published in Cynthia Garcia Coll ed. Nature and Nurture: The Complex Interplay of Genetic and Environmental Influences on Human Behavior and Development, Erlbaum 2003.

Birds do not need to be taught how to build nests. Evidently the behavior is largely instinctual. Humans need to be taught nearly everything they do (or at least need to learn through imitation). Further, our experience of our own behavior is that we make conscious choices – that we are the masters of our own ships. It thus comes as a shock to many people that genetic differences have been shown to be an important determinant of variation in a wide range of human behaviors.

Besides a number of psycho-pathologies, a large and growing list of behaviors— including major measurable aspects of personality (Loehlin 1992), political conservatism (Eaves et. al. 1997), religiosity (Waller et. al. 1990), occupational attitudes (Lykken et. al. 1993), social attitudes (Martin et. al. 1986), marital status (Trumbetta et. al. submitted), and even television watching (Plomin et. al. 1990)—have all been shown to be heritable.

Downloads

Download

Authors

Jessica L. Cohen
William T. Dickens

The IQ Paradox: Still Resolved

James R. Flynn and William T. Dickens — Tue, 05 Feb 2002 00:00:00 -0500

Published in Psychological Review, Vol. 109 #4 (2002)

Abstract

In our original paper we formalized the consensus model that environment affects IQ and IQ affects environment and showed that it can resolve the apparent paradox between high heritability and large environmental effects. Our commentators suggest that that model has undesirable properties which call its usefulness into question. Loehlin argues that IQ is persistent and that incorporating persistence into the model causes problematic behavior. Rowe and Rodgers argue that an increasing correlation of IQ and environment should have caused growing variance of IQ. Empirical evidence suggests that IQ is not sufficiently persistent to cause the problems Loehlin finds and that the correlation of IQ and environment has not grown much over time so that the reciprocal effects model need not imply increasing variance.

View full article — (PDF - 80KB)

Downloads

Download

Authors

James R. Flynn
William T. Dickens

A Foundation for Behavioral Economics

Jessica L. Cohen and William T. Dickens — Sat, 01 Dec 2001 00:00:00 -0500

Later Published in the American Economic Review, May 2002.

The core theory of behavior in Economics, which structures inquiry and provides a framework for empirical analysis, is largely responsible for the success of the discipline. Behavioral Economics (BE) challenges this theory, but has failed to provide a coherent alternative. Consequently the influence of BE has been limited. In what follows we argue that Evolutionary Psychology (EP), suitably adapted, can provide at least a partial foundation for BE. Its methods offer a way of generating theories of the origins of anomalous behaviors and of testing those theories.

Downloads

Download

Authors

Jessica L. Cohen
William T. Dickens

Have New Human Resource Management Practices Lowered the Sustainable Unemployment Rate?

Adam Posen, Jessica Cohen and William T. Dickens — Tue, 15 May 2001 00:00:00 -0400

The way work is organized in the United States has undergone a radical change in the last 20 years. Job stability has declined for long-tenured workers, there has been a large increase in the use of contract and temporary workers, especially on the manufacturing shop floor, and there has been widespread adoption of new forms of workplace organization. The business press and industrial relations experts who have traced and documented these trends often associate them with an increasingly competitive environment for U.S. business, driven by international trade and technological change.

The effects of these transformations on income distribution and productivity have been studied, but almost no attention has been paid to the effect they may be having on the ability of the economy to maintain low unemployment. This is surprising considering the coincidence of these changes with an extended decline in unemployment that seems to have produced little inflation, and evidence of a striking improvement in efficiency with which workers are matched with jobs. The combination of low unemployment and inflation suggest a decline in the Non-Accelerating Inflation Rate of Unemployment (NAIRU). Several authors have argued that such a change has taken place over the last five to 15 years. The most popular explanations suggested for such a decline ignore the changes in the organization of work and focus instead on developments on the supply side of the labor market. The possibility that there is a link between the decline in the NAIRU and the adoption of these new practices has not been developed.

In this paper we discuss recent changes in how U.S. firms hire, train, fire, compensate, and manage workers. We then develop explanations for the motivations behind these changes using interviews with human resource executives from U.S. manufacturing. Finally, we use these components to suggest how the major changes in American corporations' human resource management (HRM) practices could have led to a drop in the NAIRU. A decline in labor rents that has made queuing for high wage jobs less attractive, is an important part of our story. This decline in rents occurred even as returns to skill (and therefore wages) rose for some workers. In fact, we show that inter-industry wage differences, a measure of rents, declined in a two-step sequence with a similar shape and timing to parallel movements in the Beveridge curve—a measure of matching efficiency. These co-movements also match in some important ways the available spotty data on the adoption of innovative work practices.

Downloads

Download

Authors

Adam Posen
Jessica Cohen
William T. Dickens

Heritability Estimates Versus Large Environmental Effects: The IQ Paradox Resolved

James R. Flynn and William T. Dickens — Sun, 01 Apr 2001 00:00:00 -0500

The following is a summary of the article published in Psychological Review, the full article can be found by visiting the Psychological Review website.

Darwin's Origin of Species sparked the modern debate about genes versus environment in explaining differences between human individuals and groups. Ever since, the pendulum of scientific opinion has swung back and forth with consensus always out of reach. For the last 15 years, psychologists have been plagued by a paradox that suggests that environment is both feeble and overwhelmingly potent.

The paradox emerged from a debate about race. US whites outscore US blacks on IQ tests by 15 points. Does that gap have environmental causes or is it partially due to genes? In 1973, Arthur Jensen constructed a model that applied kinship data to group differences in IQ. Evidence from kinship studies showed identical twins separated at birth and raised in different homes grow up with very similar IQs. The fact that they have identical genes provides an obvious explanation. Jensen argued that fully 75 percent of IQ variance between individuals was due to genetic differences (a value which sits in the middle of the range recently endorsed by a select committee of the American Psychological Association for adult IQ). Jensen's model showed that a purely environmental explanation of the black/white IQ gap meant that the environment of the average US black must be as unfavorable for the development of IQ as the lowest one percent of white environments measured in terms of their effects on IQ. That simply did not seem possible.

Jensen's model seemed to preclude a purely environmental explanation for any large IQ gap between groups. Then, in 1987, Flynn showed that in nation after nation, the current generation outscores the last generation by some 9 to 20 IQ points. The gains are greatest on those tests often called the best measures of intelligence. Their size and speed dictate an environmental explanation. Flynn applied Jensen's model. An environmental explanation meant putting the current generation within the top one-tenth of one percent of the last generation in terms of environmental quality. What was known to be true was shown to be impossible.

How could solid evidence show both that environment was so feeble (kinship studies) and yet so potent (IQ gains over time)?

Dickens has proposed a model that we believe solves the paradox. It assumes that people who have an advantage for a particular trait will become matched with superior environments for that trait; and that genes can derive a great advantage from this because genetic differences are persistent. A genetic advantage remains with you throughout life, while environmental differences tend to come and go, unless sustained by the steady pressure of genes.

Take those born with genes that make them a bit taller and quicker than average. When they start school, they are likely to be a bit better at basketball. The advantage may be modest but then reciprocal causation between the talent advantage and environment kicks in. Because you are better at basketball, you are likely to enjoy it more and play it more than someone who is bit slow or short or overweight. That makes you better still. Your genetic advantage is upgrading your environment, the amount of time you play and practice, and your enhanced environment in turn upgrades your skill. You are more likely to be picked for your school team and to get professional coaching.

Thanks to genes capitalizing on the powerful multiplying effects of the feedback between talent and environment, a modest genetic advantage has turned into a huge performance advantage. Just as small genetic differences match people with very different environments, so identical genes tend to produce very similar environments—even when children are raised in separate homes.

In other words, kinship studies of basketball, no matter whether they involved people with identical genes or different genes, would underestimate the potency of environmental factors. Playing, practicing, being on a team, coaching, all of these would be credited to genes—simply because differences in them tend to accompany genetic differences between individuals. Genes might seem to account for as much as 75 percent of variance across individuals in basketball performance. If someone showed that the present generation was far more skilled at basketball than the last (as indeed they are), Jensen's math would prove that it was impossible. It would show that those aspects of environment that are not correlated with genes (which is all that environment gets credit for in kinship studies) were very feeble. So feeble that the present generation would have to be within the top one percent of the last in terms of quality of environment for basketball.

The cognitive ability differences measured by IQ tests may have the same dynamics. People whose genes send them into life with a small advantage for these abilities start with a modest performance advantage. Then genes begin to drive the powerful engine of reciprocal causation between ability and environment. You begin by being a bit better at school and are encouraged by this, while others who are a bit 'slow' get discouraged. You study more, which upgrades your cognitive performance, earn praise for your grades, start haunting the library, get into a top stream. Another child finds that sport is his or her strong suit, does the minimum, does not read for pleasure, and gets into a lower stream. Both of you may go to the same school but the environments you make for yourselves within that school will be radically different. The modest initial cognitive advantage conferred by genes becomes enormously multiplied.

Once again, just as different genes are matched with very different environments, so identical genes will be matched with very similar environments. You and your separated identical twin will get very similar scores on IQ tests at adulthood. Using Jensen's model, genes will get credit for all of the potent environmental influences you both share. And environment will appear so feeble that it could not possibly account for the huge IQ advantage your children enjoy over yourself. Our model shows why this is a mistake. It shows that kinship studies hide or 'mask' the potency of environmental influences on IQ. Therefore, they do not really demonstrate the impossibility of an environmental explanation of massive gains over time.

The model's next task it to suggest just how environment performs its demanding role. Social forces affecting the whole of society can provide something that an individual's life experiences normally do not. They provide environmental influences that are just as persistent over time as the individual's genetic endowment, and that are not at the mercy of genes. After all, the present generation has no advantage in genetic quality over the last, indeed, it is often argued that the reverse is true due to the lower fertility of the more highly educated. So between generations, the mask slips and environmental forces stand out in bold relief. Relatively small environmental differences between generations gain enormous potency just as small genetic differences between individuals did: They seize control of the powerful reciprocal causation that exists between cognitive ability and environment.

No one knows for certain what environmental trends caused massive IQ gains but we can suggest a scenario consistent with their history. There is indirect evidence that massive gains in the cognitive abilities IQ tests measure began in Britain as far back as those born in 1872. They probably began with the industrial revolution and were there waiting for IQ tests to be invented to measure them. The industrial revolution upgraded years and quality of schooling, nutrition, disease control, all things that could have had a profound influence in raising IQ, at least up to about 1950.

After 1950, in nations like the US and Britain, IQ gains show a new and peculiar pattern. The are missing or small on the kind of IQ tests closest to school-taught material like reading and arithmetic. They are huge on tests that emphasize on-the-spot problem-solving, like seeing what verbal abstractions have in common, or finding the missing piece of a Matrices pattern, or making a pattern out of blocks, or arranging pictures to tell a story.

Perhaps the industrial revolution stopped demanding progress in the basics and started demanding that people take abstract problem-solving more seriously. Post-World War Two affluence may be the key. It brought a dilution of the pragmatic depression psychology, smaller families in which children's whys were taken more seriously, work roles in which people were expected to take more initiative, more energy for making leisure more cognitively demanding, whether devoted to chess or bridge or video games or simply to conversation in which people were expected to take ideas and logic seriously.

We call these products of the industrial revolution that may have set massive IQ gains rolling 'triggers'. The model itself does not specify ultimate causes and we suggest those listed very tentatively. What the model does do is demonstrate the potency triggers would gain from seizing control of reciprocal causation between cognitive ability and environment. The most dramatic tool at their disposal is the 'social multiplier'. This posits that when something raises the average performance of society, that rise becomes a powerful cause in its own right, and raises the average performance further, and raises it further, until the original rise is greatly multiplied.

The most potent facet of our environment is other people. When something, perhaps the popularity basketball got from television, triggered greater participation in basketball, the average performance rose as individuals played more and got better. Initially, a few people learn to shoot with either hand, then others imitate them. The rise in average performance feeds back into a new challenge for each individual. Those who want to excel have to learn to pass with either hand and this spreads and raises the average performance once again. In other words, every rise in individual performance raises the group average, which forces everyone to raise their individual performance a notch higher, which raises the group average a notch higher, and so on. Even a modest environmental trigger of enhanced performance can become potent by seizing control of the social multiplier—and cause huge performance gains in a relatively short time.

The same kind of reciprocal causation explains IQ gains. Environmental triggers raise the cognitive demands of work, family interaction, leisure, and everyday conversation. Those who respond by upgrading their cognitive performance raise the average cognitive performance. Then the rising average affects your employer, family, and friends and they demand or expect more, and you (and many others) rise to meet their expectations, so the average cognitive performance jumps once again, and so on, and so on. The model quantifies this process and shows that quite plausible initial environmental changes would be enough to explain huge IQ gains—gains of 20 points over a single generation.

The model has a third task. It offers an explanation for a whole range of other phenomena that have proved baffling. Why people's genes seem to count more for IQ as they age. Why enrichment programs boost IQ a lot at the start, then little more, and then see their effects fade away after children leave the program. Why cross-racial adoptions do not raise the IQs of black adoptees to the white average. Why certain methodologies produce nonsense results, such as showing that group IQ differences known to be environmental in origin have a genetic component. And to return to the race and IQ debate, it shows that environment could explain racial IQ differences just as it explains IQ differences between generations.

Finally, the model has an overriding purpose. In principle, it applies to the dynamics of any human ability where there is positive feedback between that ability and environment. We hope it will reconcile social scientists who have divided themselves, sometimes with bitterness, between hereditarians who think genes dominant and environmentalists who think culture dominant. They are both right: It all depends on whether genetic differences or environmental factors seize control of potent processes like the social multiplier. We hope that our model will allow them all, from the psychologists inspired by Sir Cyril Burt to the anthropologists inspired by Franz Boas, to find common ground, and work together to advance our understanding of human intelligence and other important traits.

Downloads

Response to recent criticisms

Authors

James R. Flynn
William T. Dickens

Publication: Psychological Review

Options for Stabilization Policy: A New Analysis of Choices Confronting the Fed

George A. Akerlof, George L. Perry and William T. Dickens — Thu, 01 Feb 2001 00:00:00 -0500

Conventional models of the macroeconomy did not anticipate the strong U.S. expansion of the past five years and cannot explain it well even today. Those models are based on the assumption that firms and workers always fully incorporate expectations of future inflation rates into their current wage and price decisions. This assumption leads to the concept of a unique natural unemployment rate for the economy, so that pushing unemployment below this natural rate will yield to ever faster inflation.

In this policy brief, we propose an alternative to the conventional natural rate model. It is based on behavioral assumptions that we believe are more realistic than those underlying the natural rate model and that are backed by research on decisionmaking. In our model, the effect of expected inflation itself varies with the inflation rate. This leads to a range of sustainable unemployment rates. Policymakers can achieve the lowest unemployment rate by operating the economy with a low to modest rate of inflation, in the neighborhood of the rates experienced in recent years.

Whether the U.S. economy now achieves a soft landing, and whether Europe's economies continue to expand fast enough to reduce their excessive unemployment rates, may well depend on whether policymakers reject the conventional natural rate model and adopt a view of economic possibilities that is more in line with the new model presented here.

POLICY BRIEF #69

The economy rarely sees a surprise as favorable as the United States expansion of the last half of the 1990s. That expansion has cast renewed doubt on conventional models of the economy's productive potential and on the relationship between real activity and inflation.

Since the 1970s, the conventional models used by policymakers and analysts have been based on the theory of a natural rate of unemployment which describes a unique equilibrium level of employment and output for the real economy. By the mid-1990s, prevailing estimates of this natural rate, known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), warned that unemployment had already fallen to its NAIRU and that lower unemployment would produce ever faster inflation. Yet over the next five years unemployment fell to 4 percent and core inflation remained in check.

Allowing the economy to expand beyond the old NAIRU target has produced far-reaching benefits, as evidenced by comparisons with projections made in August 1996 by the Congressional Budget Office (CBO). Employment grew by 14.2 million between 1995 and mid-2000, far more than had been projected with the CBO assumption of trend growth at 6 percent unemployment. Together with faster productivity growth—some part of which probably resulted from the faster expansion of the period—this resulted in real Gross Domestic Product (GDP) rising by 12 percent more than had been projected. And rather than a $204 billion federal budget deficit for fiscal year 2000 that the CBO had projected in 1996, the Treasury reported a record $237 billion surplus for 2000, with a strong economic expansion accounting for most of the difference. Whether this historic expansion now transitions into a soft landing for the economy may depend on whether policymakers reject the prescriptions of the conventional NAIRU model and on what alternative view informs their decisions.

Even before its failure to account for U.S. performance of recent years, the model of a relatively constant NAIRU had far less empirical support than its wide acceptance would suggest. Looking back at the first half of the 1960s, an earlier period of low inflation and rapid growth, recent NAIRU studies estimate the economy was at the threshold of accelerating prices by 1963. Yet at that time most economists thought that resources were underutilized and that the economy needed stimulus. In fact, unemployment was steadily reduced without any speedup of inflation until 1966, when the Vietnam war was in full swing. More generally, nowhere have natural rate models worked in periods of low inflation and high unemployment, circumstances in which they predict growing deflation which has never been observed. Nor have they performed particularly well in periods of high inflation. In Europe, the model could only be made consistent with developments over the past two decades by inventing ways to let NAIRU track actual unemployment, which emptied the model of content.

Our New Model

We have developed an alternative to the natural rate model that is based on behavioral assumptions that we find more realistic. They also better fit the facts. The key behavioral assumption that we change concerns the role of expectations in the inflation process. Natural rate models assume that both price and wage setters set prices to exactly offset expected inflation. In econometric estimation this amounts to constraining the effect of expected on actual inflation to be one for one, meaning that changes in expected inflation change actual inflation by the same amount.

The previous controversy in empirical work has been about how to model the formation of expectations so as to formulate and test this assumption. In contrast we see how people use expectations, rather than how they form them, as the key to modeling inflation. We do not accept the standard assumption that people always make the best use of all available information and turn instead to evidence about how people actually use information in making decisions. We recognize that firms and workers are barraged with more relevant information than they can fully process, so that when inflation is low, and thus relatively unimportant for economic decisionmaking, it will be ignored or not given full weight. But when inflation is high it will be the center of attention. This leads us to a model in which the effect of expected inflation on actual wage and price setting will itself vary with the rate of inflation—the effect is small when inflation is low and close to one-for-one when inflation is high.

That small change to the standard model makes a big difference. In natural rate models, the economy has a unique sustainable rate of unemployment. Attempts to push the economy to lower unemployment rates and higher levels of output inevitably lead to ever higher inflation and, eventually yield no reduction in unemployment. By contrast, we find the economy can operate over a range of sustainable unemployment rates corresponding to a range of low-to-moderate rates of inflation. In our model, the old natural rate idea is a special case that is relevant only at high inflation rates.

The difference is crucial both for how models are specified and estimated, and for understanding the options open to policymakers. For specifying and estimating key relations, estimates that are constrained to produce a NAIRU will underestimate the economy's potential, especially during periods of low inflation. For policymaking, either using NAIRU estimates as a target or pursuing zero inflation—as adherents of natural rate models often advocate—will leave unemployment wastefully high and the economy operating well below its potential. In our own analysis, the lowest sustainable unemployment rate is achieved with moderate inflation and is well below the unemployment rate associated with complete price stability.

We now look more closely at econometric evidence that casts doubt on the NAIRU model and then at the behavioral evidence that calls into question the microeconomic underpinnings of natural rate theory. We then turn to our model and its implications.

Preliminary Time Series Evidence

In practice, NAIRU models assume that people form their expectations of future inflation based on an average of past inflation. This average is used in statistical analysis as the measure of expected inflation and, in NAIRU models, it is assumed to move current inflation one-for-one. In econometric terms, that means expected inflation is constrained to have a coefficient of 1.0 in moving the actual inflation rate. Yet this assumption is not consistent with the data.

William Brainard and George Perry recently estimated a historical relation between inflation and unemployment, commonly known as the Phillips curve, using an unconventional estimation technique that permits all the coefficients of the model to vary over time. While the other coefficients of the model were remarkably stable over the last forty years, the coefficient on expected inflation—which the NAIRU model assumes has a constant value of 1.0—in fact varied considerably. Starting from low values in the low-inflation years before the 1970s, estimates of this key coefficient rose to near 1.0 with the high inflation that accompanied the two OPEC oil price shocks, but then declined again to low values when inflation subsequently fell. Thus, this final NAIRU assumption is approximately correct when inflation is high, but not when inflation is at low to moderate levels.

As a preliminary step in our own work, we estimated separate Phillips curves for periods of low and high inflation. We sorted the period from 1954 through 1999 into two samples: low-inflation quarters when the trailing five-year average of inflation in the Consumer Price Index (CPI) was below 3 percent (or, alternatively, 2.5 percent), and high-inflation quarters with this average in excess of 4 percent. The samples have mean inflation rates of 2.0 percent and 6.3 percent, respectively. We then estimated a large number of specifications in which we varied the measure of unemployment and the measure of inflationary expectations. Our findings support the Brainard and Perry results. We consistently found the coefficient on inflationary expectations to be substantially larger in regressions estimated with the high-inflation samples than for the comparable specification estimated with the low-inflation samples.

How People Use Expectations

We now turn to the behavioral underpinnings of our model. Natural rate, or NAIRU, models assume expected inflation is always fully incorporated into the price- and wage-setting decisions of firms and workers. However, a wealth of evidence on actual behavior suggests that this assumption is wrong. For example, psychological studies show that decisionmakers often "edit" the information available to them, ignoring much that is potentially relevant in order to concentrate on the few factors they deem most important. Furthermore, studies of perception show a stimulus must pass a threshold before it is even perceived, let alone used.

In addition, from interviews with compensation professionals, we infer that wage setters do not behave in the way that most economic models assume. Rather than choosing a real wage target and then adjusting it fully for expected inflation, they mix information about inflation with a variety of other information relevant to wage setting in unsystematic ways that are not likely to yield the result economists assume.

Research by Robert Shiller, reported in a 1997 volume on reducing inflation, and research on money illusion by Eldar Shafir, Peter Diamond, and Amos Tversky, published in the Quarterly Journal of Economics, shows that employees systematically underestimate the tendency of inflation to boost their own nominal wages. Therefore, in periods of moderate inflation, so long as their wages do not decline, employees view favorably the salary increases they get and generally remain satisfied with their jobs.

Inflationary Expectations and the New Model

We now sketch how we incorporate expectations into our formal model relating inflation and unemployment. Firms set wages and prices, and workers respond to the wages offered according to their view of job and wage opportunities outside the firm. The crucial issue is how wage and price setting varies with inflation.

Even when inflation is low, some firms' wage and price setting fully incorporates expected inflation. In other firms, wage and price setting responds fully to current conditions in their labor market, but less than fully to expected inflation, perhaps even ignoring it completely. Because all firms adjust to current market conditions each time they set wages, the wage in firms that fail to take full account of inflation trails the average wage, though only by a small, noncumulating percentage. Prices in all firms are a markup over expected unit labor costs. The cost in lost profits from less than complete attention to inflation is negligible when inflation is low, but this cost grows quickly with inflation. As a consequence, the fraction of firms that fully incorporate expected inflation in setting their own wages and prices varies with the inflation rate. In a climate of little or no inflation, a large fraction of firms do not fully adjust their wages and prices, but this fraction declines when inflation rates are higher.

This behavior by firms has important implications for the macroeconomy as illustrated in figure 1, which traces out the trade-off between equilibrium unemployment and inflation for plausible values of the other parameters in the model.

At zero inflation, it does not matter whether firms pay attention to inflation, and equilibrium unemployment corresponds to what would be the conventional natural rate. (In a 1996 study, we showed that at zero inflation, unemployment would be above the natural rate because some inflation is necessary to allow adjustment of relative wages. We ignore that effect here to simplify the exposition of our present model, which focuses on expectation. In reality, both effects are important and coexist.) When inflation is between zero and some moderate rate, higher inflation within this range is accompanied by lower unemployment.

This trade-off reflects two opposing effects. The first effect concerns firms that continue to pay less than full attention to inflation. At a higher inflation rate, the wages and prices of these firms fall somewhat behind those of firms that do pay full attention. As a result, these firms sell more goods and employ more workers than they would if they set their prices higher. The lower prices of their goods also leave consumers with more to spend, increasing demand for the goods of other firms, and raising total employment. The second effect concerns firms that change their behavior. At the higher inflation rate, those firms shift their pricing to fully incorporate expected inflation and, as they do, wages and prices rise more, reducing some of the benefits to employment and output from the first effect.

In the low-to-moderate inflation range, the first effect dominates and higher inflation is associated with lower unemployment. But beyond some inflation rate the second effect dominates and the trade-off goes the other way: higher inflation is associated with higher unemployment.

The left-most point in the graph in figure 1 represents the lowest sustainable unemployment rate. Inflation at this point is moderate but also greater than zero. Unemployment associated either with zero inflation or high inflation is significantly higher. The short-run Phillips curve that follows from this model is one in which the coefficient on expected inflation rises with inflation and eventually approaches one.

Empirical Tests of the Model

We have estimated and tested our model with post-war United States data. The key test is whether the coefficient on expected inflation varies in the way we predicted in our theory. The estimating equation includes a term to capture that effect, if it is in fact present in the data. We specified the term in a variety of ways. We used a number of measures of expected inflation itself, including alternative averages of past inflation as well as direct survey measures of expected inflation, and several alternative measures of unemployment and of price and wage inflation.

The large number of specifications that are available from these combinations of data provide a check on the robustness of our findings. Finally, while all the data we need are available from the first quarter of 1954 through the end of 1999, we sometimes restricted the period of estimation to end in the fourth quarter of 1989 so that the results would not be driven by the 1990s episode of low inflation and falling unemployment.

Nearly all the estimates confirmed our theory and indicated that large, sustainable gains in employment are available by operating the economy at inflation rates moderately above zero rather than either at zero inflation or high inflation. At zero or high inflation rates, the equilibrium in our model corresponds to the natural unemployment rate in conventional models.

To summarize the range of estimates, we calculated the inflation rate associated with maximum employment and the difference between the corresponding unemployment rate and the natural unemployment rate. This difference measures the sustainable gains in employment that are attainable. Not surprisingly, the large number of specifications generates a wide range of point estimates. The densest cluster of estimates spans a range from 1.5 to 3 percent for the inflation rate that maximizes employment in the long run. The estimated unemployment reduction from operating the economy at that inflation rate (rather than at zero or high inflation) falls mainly in the range from 0.5 to 3.0 percentage points.

Guides For Policymakers

Although these estimates provide support for the qualitative features of the model, they do not pin down precise targets for inflation and unemployment. Indeed, it would be unrealistic to seek precise estimates. However, our main results and the departures from conventional natural rate models that they identify appear to be robust and do provide useful guides for policy.

Rather than a unique natural rate of unemployment, the economy has a range of sustainable unemployment rates that are consistent with moderate inflation. Zero inflation is an inappropriate policy target because it raises the sustainable rate of unemployment by a significant amount. High inflation is bad for the same reason, as well as because of other distortions and inequities. Moderate inflation, which includes the range of experience of recent years, with the core CPI rising at a 2 to 2.5 percent annual rate, allows the economy to operate with low unemployment. Such an inflation rate yields maximum prosperity.

The economy is now slowing from the very rapid growth rates of the past few years. Whether the soft landing that everyone is hoping for can be achieved may well depend on whether policymakers managing this slowdown rely on conventional models and prescriptions that aim for complete price stability or, instead, take account of the analysis described here. That analysis suggests policymakers should aim to maintain the moderate core inflation rates of recent years and avoid the substantial increase in unemployment that conventional NAIRU models suggest is inevitable.

A similar choice confronts policymakers in the new European Monetary Union who have only recently seen their persistently high unemployment rates begin to fall. If they now prematurely tighten policies in order to pursue price stability, they are likely to interrupt the expansion before full prosperity has been restored in Europe.

Downloads

Download

Authors

Publication: Brookings Institution

Comments on Charles Wyplosz Paper: Do We Know How Low Should Inflation Be?

William T. Dickens — Thu, 02 Nov 2000 00:00:00 -0500

Both the comments and the paper were presented at The First European Central Banking Conference, held in Frankfurt, Germany, November 2-5, 2000.

Introduction

A little inflation may be a good thing in a modern economy. In particular, it may be possible to maintain lower rates of unemployment with low inflation than with zero or very low inflation. In two recent articles, George Akerlof , George Perry and I (1996,2000) (hereafter, ADP) have presented evidence for two specific mechanisms by which inflation may affect the equilibrium level of unemployment. We modeled those mechanisms, and argued the case that large permanent reductions in unemployment may be obtained by moving from either a high or very low rate of inflation to a moderate rate (2-4% in the United States). The two mechanisms we examined were nominal rigidity in wage setting, and near rationality in the use of inflationary expectations in price and wage setting.

In these papers we estimated Phillips Curve relations from which we deduced the magnitude of the effects of nominal rigidity and near rationality on the long-run relationship between inflation and unemployment. But these empirical exercises do little to verify the nature of this relationship because that was simply assumed when we accepted the dictates of our theory in setting up the specification we estimated. In this paper Charles Wyplosz takes a very different approach to roughly the same empirical problem. He estimates models of unemployment in which he allows the NAIRU, or natural rate of unemployment, to vary with the rate of inflation in a very general way. Such an approach has advantages and disadvantages relative to the approach my colleagues at The Brookings Institution and I have taken. Below I discuss Wyplosz's results and present some of my own. Taken together, our results suggest the possibility that very low rates of inflation may cause unemployment to be higher than it would be at moderate rates of inflation in the Euro zone.

View Wyplosz's paper from the ECB website » (PDF)

Downloads

Authors

William T. Dickens

Publication: The First European Central Banking Conference