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Volume 12, Issue 1, November 2010

The Research Agenda: Ariel Burstein on International Trade and Macroeconomics

Ariel Burstein is Associate Professor of Economics at UCLA. His research interests lie in exchange rates, trade and business cycles. Burstein's RePEc/IDEAS entry.

1. Introduction

My research examines a variety of central questions in international macroeconomics and trade, such as: Does international trade improve welfare by stimulating innovation? To what extent can the increase in globalization account for the observed rise in wage inequality in developed and developing countries? What are the aggregate consequences of reallocating firm-embedded know-how across countries in the form of FDI? Why are relative prices across countries so volatile over time? A unifying theme of my research is to develop quantitative models and bring in new data to shed light on these classic questions. In this article I take the opportunity to report on the progress of some of my recent and ongoing work in addressing some of these questions.

2. General Equilibrium Perspectives on Innovation by Firms

In this work, Andrew Atkeson and I explore a commonly held view that international trade has extra benefits because it stimulates innovation by firms. According to this idea, reductions in trade costs make large firms that export face a bigger global market, which increases their incentives to innovate to reduce costs. Hence, the larger exposure to trade leads to an increase in productivity by some firms, which contributes to raising aggregate productivity and welfare.

To assess this view, Andy and I (Atkeson and Burstein 2010a) develop a general equilibrium model that captures the dynamic decisions of heterogeneous firms to exit, export, and invest in innovation to both improve existing products (process innovation) and create new products (product innovation). This model can then be used to aggregate-up from firm-level decisions to obtain a deeper understanding of how aggregate productivity should be expected to respond in general equilibrium to changes in the economic environment such as international trade costs. Our model extends Hopenhayn's (1992) and Luttmer's (2007) model of firm dynamics with exit and entry of new firms to include a R&D decision by incumbent firms following Griliches' (1979) model of knowledge capital. We consider an open economy version of these models with fixed and marginal international trade costs, as in Melitz (2003).

We propose a simple algorithm to assess the impact of a change in the cost of international trade on aggregate productivity and welfare in the long run. A striking feature of our results is that, across a range of model specifications that we can solve analytically, consideration of the endogeneity of firms' decisions to exit, export, and invest in process innovation have no impact, to a first-order approximation, on our models' implications for the long-run impact in general equilibrium of a change in international trade costs on aggregate productivity. In fact, to a first-order approximation, one would obtain the same results for the long run change in aggregate productivity in a simple model in which firms' exit, export, and process innovation decisions were held fixed (completely inelastic) and only firms' entry decisions responded to changes in the economic environment.

This is not to say that there are no important changes in firm dynamics that result from a change in international trade costs. In fact, for certain assumptions about the elasticity of incumbent firms' investments in process innovation with regard to changes in the costs or benefits of such innovation, our model predicts dramatic changes in these firms' innovative efforts and productivity growth rates. Cutting trade costs stimulates process innovation for exporting firms, as these firms seek to grow their profits by selling to a larger market at lower costs. Hence, a reduction in trade costs leads to a reallocation of production, export status, and investments in process innovation from smaller, less-productive, non-exporting firms to larger, more-productive, exporting firms and this reallocation leads to an increase in the productivity of the average firm and in the share of exports in output (some of these implications are further described in Burstein and Melitz 2010).

Yet, in general equilibrium, this reallocation does not have a first-order effect for the model's implications for long run aggregate productivity. The rise in the productivity of the average firm stemming from the improvements in process innovation and entry into export markets is offset by a reduction in product innovation. Why is that? If other firms in the economy become more productive as they innovate more, this drives down the profitability of entering firms that tend to be small non-exporters competing with globalized firms. This is the self-limiting nature of innovation: the stimulating effect of process innovation and entry into exporting is largely offset by a reduction in product innovation.

We evaluate the strength of this offset in a version of the model that relaxes some of the assumptions that give rise to our stark analytic result described above. In particular, we consider a parameterized version of our model that accounts for some salient features on the share of exporters in output and employment and the firm size distribution in the U.S. economy. In one of our experiments, we consider a reduction in trade costs that more than doubles the share of exports in output. This greatly stimulates the innovative activity of exporters, causing a surge in average productivity: long run average productivity rises by 7.5 times the percentage change in trade costs. But this increase in average productivity is almost entirely offset by a reduction in product innovation, which falls by a factor of 7.4 times the percentage change in trade costs. Moreover, this long run rise in aggregate productivity stemming from the increase in innovation intensity turns out not to make a big difference for welfare of the representative consumer. This is due to the fact that after firms increase their process innovation, it takes a long time to materialize and impact aggregate productivity.

Andy and I (Atkeson and Burstein 2010b) are currently using our framework to more generally assess the aggregate implications of changes in economic policies that affect the costs and benefits to firms of innovative activity. In order to allow a role for welfare-enhancing policies in our model, we include spillovers from R&D. Our model nests widely-used models of semi-endogenous and endogenous growth (see e.g. Acemoglu 2009) based on the value of a key parameter determining to what extent the productivity increase in some firms crowds-out profits of other firms. In the knife-edge case in which a firm's profits are independent of other firms' productivities, business R&D is the engine of endogenous growth. In contrast, if productivity increase in incumbent firms crowds-out profits of other firms, business R&D is not the engine of growth, as in semi-endogenous growth models.

When business R&D is not the engine of growth, we show that the calculation of the impact of a wide array of policies directed at inducing innovation by firms on aggregate productivity in the long run can be boiled down to a relatively simple accounting procedure that is straightforward to implement. Namely, to a first-order approximation, the aggregate effects of a subsidy on innovation are the same as the effects of a subsidy on variable profits, keeping innovation decisions of incumbent firms unchanged. This procedure can be understood as follows. First, subsidies on innovation are equivalent to subsidies on firms' variable profits because subsidizing the return to innovation is equivalent to subsidizing the cost of innovation. Second, an increase in innovation by incumbents lowers profits of entrants, keeping aggregate productivity unchanged. Once again, macroeconomic forces limit the aggregate impact of a change in incumbents' innovation decisions.

We identify the key parameters in our model that shape the effects of innovation policies, and revisit previous empirical approaches to estimating these effects through the lens of our model. As suggested above, data on the response of R&D of incumbent firms to changes in innovation subsidies is not informative on the aggregate effects of innovation policies. Moreover, because the crowding out effects we identify arise in general equilibrium, data on the response of output of individual industries to changes in innovation policies is informative only as long as the comprehensiveness of these policy changes across industries is known. This is because, in our model, the effects on output in an industry from an innovation subsidy that affects only this industry are very different from those of a subsidy to a large number of industries.

Finally we ask, as does Griliches (1998), whether R&D policies and R&D spillovers can account for a significant proportion of differences in per capita income and measured TFP. As discussed in Prescott (1997) and Klenow and Rodriguez-Clare (2005), in constructing a theory of R&D or other unmeasured capital that can account for large differences in income per capita across countries, two important challenges for such a theory are that (1) it does not require implausibly large differences in R&D or unmeasured capital investment rates across time or countries, and (2) it does not require implausibly long transition dynamics from one steady-state to another.

3. Globalization and the skill premium

To what extent can the growth of trade and multinational production (MP) account for the rise in the skill premium in developed and developing countries? What are the different implications for the skill premium in developed countries of globalization with developing countries versus globalization with developed countries?

The classic model to study the link between international trade and inequality is the Heckscher-Ohlin (H-O) model. According to this theory, trade liberalizations shift factors of production between sectors towards a country's comparative advantage sector and raise the relative return to the factor that is used intensively in this sector --- the between effect. International trade increases the skill premium in countries that have a comparative advantage in skill-intensive sectors, and lowers the skill premium in countries that have a comparative advantage in unskill-intensive sectors. Previous empirical work (see e.g. Goldberg and Pavnick 2007), however, has cast doubt on the importance of trade in accounting for the skill premium because (i) inequality has increased both in countries abundant in unskilled labor and in countries abundant in skilled labor, and (ii) most factor reallocation occurs within rather than across sectors. An alternative interpretation of this evidence, however, is that the standard H-O model abstracts from other potentially important channels beyond the between effect through which globalization affects the skill premium.

To allow for such additional channels, Jonathan Vogel and I (Burstein and Vogel 2010a) extend the H-O model in three dimensions. First, motivated by the large heterogeneity in size and export status within sectors, we introduce productivity heterogeneity across producers within sectors. Second, motivated by the observation that, within sectors, exporters tend to be more skill-intensive than non-exporters, we allow for skill-biased technology at the producer level. Third, we allow for producers to use their technologies to produce in foreign countries, engaging in multinational production (MP). MP is an important form by which producers supply foreign countries beyond international trade (for example, sales of U.S. foreign affiliates are more than twice as large as the value of U.S. exports).

Following a reduction in trade and MP costs, our extended model predicts within sector factor reallocation from less productive non-exporters to more productive exporters, as in recent international trade models with producer heterogeneity. If a producer's productivity is positively correlated with its skill intensity, then this reallocation of labor across producers within sectors raises the demand for skilled labor and the skill premium --- the within effect. In contrast to the standard Hecksher-Ohlin model, the within effect implies that the skill premium may rise in all countries. Hence, our extended model gives globalization (both trade and MP) a better chance to account for the rise in the skill premium in developed and developing countries. Which force dominates and by how much is a quantitative question that we address in our quantitative analysis.

We consider a parameterized four-country version of our model (matching U.S. trade and MP volumes in 2006 with skill-abundant and scarce countries) to conduct a series of counterfactuals. To isolate the role of international trade in shaping the skill premium, we first consider a reduction in trade costs moving from autarky to the level of trade in 2006, holding all other exogenous variables fixed (including factor endowments) and abstracting from MP. This is a "but for" analysis: What would the skill premium be, but for the availability of international trade opportunities? The rise in the skill premium caused by trade is 1.8% in the U.S. and 2.9% in skill-scarce countries.

The two central messages from these results are as follows. First, in contrast to the standard H-O model, our parameterized model is consistent with a rising skill premium in all countries. The skill premium rises in all countries because the within effect is relatively strong compared to the between effect. The between effect is weak because, in our parameterization as in the data, the factor content of trade in the U.S. is not very high (in fact, under some assumptions of our model, the between effect is fully determined by the factor content of trade --- see also Burstein and Vogel 2010b). Given that the between effect is weaker than the within effect, how much the U.S. trades matters more for its skill premium than with whom the U.S. trades (i.e. whether it trades with Europe or China). Second, the magnitudes of the changes in the skill premium of moving from autarky to 2006 levels of trade are quite small relative to, for example, the 24% rise in the (composition-adjusted) U.S. college-high school wage gap between 1966 and 2006 (see, e.g., Acemoglu and Autor 2010).

The relatively small trade share in the U.S. plays a critical role in explaining the relatively small impact of trade on the U.S. skill premium in our model. The share of MP in output, however, is at least twice as high. When we simulate a reduction in both trade and MP costs moving from autarky to the levels of trade and MP in 2006, the rise in the skill premium is much larger: 4.8% in the U.S. and 6.5% in the skill-scarce countries. MP is at least as important as international trade for determining the impact of globalization on the skill premium.

In order to assess the extent to which the growth of trade and MP can account for the rise in the skill premium between 1966 and 2006 in the U.S., we consider a second counterfactual in which we choose parameters to match the growth of trade and MP between these years. In this counterfactual we do not hold endowments or technologies fixed, but instead we target the increase in the supply of skilled labor and the greater growth of the skill-scarce countries between 1966 and 2006 and we allow for exogenous skill-biased technology growth to match the 24% increase in the U.S. skill premium. In our preferred, baseline parameterization, we show that in the absence of globalization, the rise in the skill premium in the U.S. would have been 1/9th smaller than the observed rise in the skill premium over this time period (in a less conservative parameterization in which we choose parameter values so that, given trade and MP shares, the between and within effects are strengthened, we find that in the absence of globalization the rise in the skill premium in the US would have been 1/5th smaller than the observed rise over this time period).

Whereas we use a structural, parameterized model to quantify the impact of international trade and MP on the skill premium, the empirical literature has mostly focused on three alternative approaches that emphasize: the factor content of trade, the extent of between-sector factor reallocation, and the mandated wage equation. We show that while each of these alternative approaches may provide estimates of the impact of international trade on the skill premium via the between effect, they do not capture the impact of the within effect of trade and MP. Using data generated by our model, in which the within effect is relatively strong, we show that these approaches underestimate the rise in the skill premium stemming from the increase in globalization.

Whereas in our current work we capture two important forces in the debate on globalization and the skill premium---the between and within effects---and incorporate both trade and MP, we abstract from other interesting and potentially important considerations discussed in the literature, such as endogenous skill-biased innovation or capital accumulation with capital-skill complementarity. We think that providing a framework that allows for such additional considerations is a fruitful area for future research to more fully assess the quantitative effects of globalization on inequality.

4. Understanding fluctuations in international relative prices

Why are relative prices across countries, as measured by real exchange rates (RERs), so volatile over time, and why do they so closely track movements in nominal exchange rates? These questions are at the heart of the discussions on optimal exchange rate policy (i.e.: by depreciating the exchange rate, countries may be able to reduce the relative price and raise the output of the goods they produce) and on the role of the border in creating frictions to the international trade of goods (i.e.: if trade costs were small, international trade should arbitrage large differences in relative prices across locations). The high correlation between RER and nominal exchange rate movements has been widely suggestive of nominal macroeconomic non-neutralities (see e.g. Mussa 1986).

As a starting point to understand these movements in international relative prices, consider simple models of price setting with perfect competition or imperfect competition and constant markups, in which prices change one-to-one with movements in marginal production costs. According to these models, the relative price of a traded good produced in a common location and sold in two countries (subject to a linear transportation technology) should remain constant over time. This is the hypothesis of relative purchasing power parity (relative PPP). However, a large body of empirical work suggests that relative PPP does not provide an accurate representation for movements in relative prices of many goods (see e.g. the survey in Goldberg and Knetter 1995). Another implication of models with constant markups is that, if all goods can be traded at no cost across countries, consumer-price-based RERs should be constant over time. However, RERs are very volatile, even for tradeable goods (see e.g. Engel 1999).

In order to account for the observed deviations of relative PPP and the large movements of RERs for tradeable goods, researchers have considered two key sources of departure from the constant markup costless-trade benchmark. First, many goods are not traded (see e.g. Burstein, Eichenbaum, and Rebelo 2005), and even traded goods include a substantial non-traded distribution component (see e.g. Burstein, Neves, and Rebelo 2003). Changes in relative prices across countries for these goods may simply reflect movements in relative production or distribution costs across locations. Second, movements in international relative prices may be explained by the decision of individual firms to engage in pricing-to-market --- that is, to systematically vary over time the markup at which they sell their output in different locations (see e.g. Dornbusch 1987 and Krugman 1987). These movements in relative markups can stem from nominal rigidities that leave prices in the buyer's currency unchanged to exchange rate movements, or from some feature of demand or competition that gives rise to movements in demand elasticities (and hence markups) across destinations.

Identifying whether movements in relative prices across countries reflect movements in relative markups or in relative costs is a key ingredient for the design of optimal exchange rate policy. Movements in relative prices of individual goods across countries that reflect changes in relative costs across locations are typically efficient, while movements in relative prices that reflect changes in relative markups across locations are typically inefficient (see e.g. Engel 2010). Hence, changes in exchange rates have very different normative implications in both models.

Nir Jaimovich and I (Burstein and Jaimovich 2009) take the challenge of documenting the role of pricing-to-market in accounting for the observed movements in international relative prices. We do so using detailed information on prices in Canada and the U.S. at the level of individual products. In particular, we use scanner data for the period 2004-2006 from a major retailer that sells primarily nondurable goods in multiple locations in Canada and the U.S. For each product, we observe the retailer's purchase cost from the vendor, i.e. the wholesale price, in each location and over time. We also identify the country of production of individual products that are sold in Canada and the U.S. Under the assumption that goods produced in a common location and sold in multiple locations are subject to common percentage changes in the marginal cost, movements in relative prices across locations for these goods must arise from changes in relative markups. With this information, we can thus assess the extent to which movements in relative prices of individual products across locations reflect the practice of pricing-to-market by producers and wholesalers.

Our findings demonstrate that pricing-to-market plays an important role in accounting for movements in international relative prices. We show that movements in aggregate RERs, constructed by averaging changes in relative prices across countries (expressed in a common currency) over a large set of products sold in both Canada and the U.S., closely track the large rise in Canada-U.S. relative unit labor costs over our sample period (which are mainly accounted for by the appreciation of the Canadian dollar against the U.S. dollar). For nontraded goods that are produced in each country and sold in both countries, these movements in aggregate RERs can simply reflect changes in relative costs across countries. However, the fact that this pattern holds as well for traded goods produced in a common location and sold in both countries implies that in response to the appreciation of Canada-U.S. labor costs, markups in Canada increase systematically relative to markups in the U.S.

Pricing-to-market does not stem, in a pure accounting sense, from large movements in nominal exchange rates and small movements in nominal prices in each country. Instead, nominal prices of individual products change frequently and by large magnitudes. Moreover, changes in international relative prices at the level of individual products, product-level RERs, are very large, roughly four times as volatile (at quarterly frequencies, excluding temporary price changes in each location) as the Canada-U.S. nominal exchange rate, even for traded goods. Hence, while cross-country differences in markups on average track movements in nominal exchange rates and relative labor costs, the idiosyncratic product-specific component of pricing-to-market is significant. We also show that the idiosyncratic and aggregate components of pricing-to-market are much more prevalent across countries than across regions within countries.

Our empirical findings relate to a recent and rapidly growing literature documenting the behavior of international relative prices for tradeable (but not necessarily traded) goods using detailed product-level information (see e.g. Crucini and Shintani 2008, Broda and Weinstein 2008, and Gopinath, Gourinchas, Hsieh, and Li 2010). Our empirical contribution is to measure the extent to which movements in relative prices of matched individual products across locations reflect pricing-to-market by producers and wholesalers, which can do because of two unique features of our data. First, by observing wholesale prices, we can more accurately measure movements in relative markups at the producer level than if we used retail prices, which contain a significant non-traded distribution component. Second, by using information on the country of production of individual products, we can identify goods that are actually traded, and infer changes in relative markups for these goods from observed movements in relative prices across locations. Fitzgerald and Haller (2008), like us, also find evidence of pricing-to-market by exporters in response to exchange rate movements using detailed firm-level data.

Our empirical findings raise some important questions: Why do relative markups systematically track movements in relative costs across countries, even if nominal prices of individual products change frequently and by large amounts? Why is pricing-to-market more prevalent across countries than within countries? Nir and I address these questions using a simple model of pricing-to-market and international trade with flexible prices (that extends my previous work, Atkeson and Burstein 2007, 2008). The international border plays an important role in our model by segmenting competitors across countries (more so than within countries), leading to the practice of pricing-to-market by exporters that optimally change their markup across locations (more so across countries than within countries) in response to idiosyncratic shocks and changes in aggregate relative labor costs.

Our model is highly stylized in order to gain analytical tractability and to help us identify key forces that can account for the observed movements in product-level and aggregate RERs. In doing so, we abstract from important industrial organization considerations (for models of incomplete pass-through that incorporate some of these considerations, see e.g. Goldberg and Hellerstein 2007 and Nakamura and Zerom 2010). An important question for future research is whether richer models of demand and market structure can give rise to idiosyncratic and aggregate movements in relative markups across locations (i.e. differences in pass-through across locations) like the ones observed in the data.

References

Acemoglu, Daron. 2009. Introduction to Modern Economic Growth. Princeton University Press, Princeton, NJ.
Acemoglu, Daron, and David Autor. 2010. "Skills, Tasks and Technologies: Implications for Employment and Earnings." in: Handbook of Labor Economics, Volume 4, forthcoming.
Atkeson, Andrew and Ariel Burstein. 2007. "Pricing-to-Market in a Ricardian Model of International Trade." American Economic Review, 97(2): 362-367.
Atkeson, Andrew and Ariel Burstein. 2008. "Pricing-to-Market, Trade Costs, and International Relative Prices." American Economic Review, 98(5): 1998-2031.
Atkeson, Andrew, and Ariel Burstein. 2010a. "Innovation, Firm Dynamics, and International Trade." Journal of Political Economy, 118(3): 433:484
Atkeson, Andrew, and Ariel Burstein. 2010b. "What is the impact of innovation policy on aggregate output and welfare?" Working paper. UCLA
Broda, Christian, and David Weinstein. 2008. "Understanding International Price Differences using Barcode Data." NBER working paper 14017. National Bureau of Economic Research.
Burstein, Ariel, Joao Neves, and Sergio Rebelo. 2003. "Distribution Costs and Real Exchange Rate Dynamics During Exchange-Rate-Based Stabilizations." Journal of Monetary Economics, 50(6): 1189-1214.
Burstein, Ariel, Martin Eichenbaum, and Sergio Rebelo. 2005. "Large Devaluations and the Real Exchange Rate." Journal of Political Economy, 113(4): 742-784.
Burstein, Ariel and Nir Jaimovich. 2009. "Understanding Movements in Aggregate and Product-Level Real Exchange Rates." Mimeo. UCLA.
Burstein, Ariel and Marc Melitz. 2010. "Trade Liberalizations and Firm Dynamics." Working Paper. UCLA.
Burstein, Ariel and Jonathan Vogel. 2010a. "Globalization, Technology, and the Skill Premium: A Quantitative Analysis." NBER Working Paper 16459. National Bureau of Economic Research.
Burstein, Ariel and Jonathan Vogel. 2010b. "International Trade Patterns, the Skill Premium, and Heterogeneous Firms." Mimeo. Columbia University.
Crucini, Mario and Mototsugu Shintani. 2008. "Persistence in law of one price deviations: Evidence from micro-data." Journal of Monetary Economics, 55(3): 629-644.
Dornbusch, Rüdiger. 1987. "Exchange Rates and Prices." American Economic Review, 77(1): 93-106.
Engel, Charles. 1999. "Accounting for U.S. Real Exchange Rate Changes." Journal of Political Economy, 107(3): 507-538.
Engel, Charles. 2011. "Currency Misalignments and Optimal Monetary Policy: A Reexamination." American Economic Review, forthcoming.
Fitzgerald, Doireann and Stefanie Heller. 2008. "Exchange Rates and Producer Prices: Evidence from Micro-Data." Mimeo. Stanford University.
Goldberg, Pinelopi K., and Rebecca Hellerstein. 2007. "A Structural Approach for Identifying the Sources of Local Currency Price Stability with an Empirical Application." NBER Working paper 13183.
Goldberg, Pinelopi K., and Michael Knetter. 1997. "Goods Prices and Exchange Rates: What Have We Learned?" Journal of Economic Literature, 35(3): 1243-1272.
Goldberg, Pinelopi Koujianou and Nina Pavcnik. 2007. "Distributional Effects of Globalization in Developing countries." Journal of Economic Literature, 45(1): 39-82.
Gopinath, Gita, Pierre-Olivier Gourinchas, Chang-Tai Hsieh, and Nicholas Li. 2010. "International Prices, Costs and Markup Differences." American Economic Review, forthcoming.
Griliches, Zvi. 1979. "Issues in Assessing the Contribution of Research and Development to Productivity Growth." Bell Journal of Economics, 10(1): 92-116.
Griliches, Zvi. 1998. "The Search for R&D Spillovers." in: R&D and Productivity: The Econometric Evidence. National Bureau of Economic Research.
Hopenhayn, Hugo. 1992. "Entry, Exit, and Firm Dynamics in Long Run Equilibrium." Econometrica 60(5): 1127-1150.
Klenow, Peter J. and Andres Rodriguez-Clare. 2005. "Externalities and Growth." in: Philippe Aghion and Steven Durlauf (eds.), Handbook of Economic Growth, volume 1, chapter 11, pages 817-861.
Krugman, Paul. 1987. "Pricing to Market When the Exchange Rate Changes." in: S. W. Arndt and J. Richardson (eds.), Real Financial Linkages Among Open Economies, London: MIT Press.
Luttmer, Erzo G.J. 2007. "Selection, Growth, and the Size Distribution of Firms." Quarterly Journal of Economics, 122(3): 1103--1144.
Melitz, Marc. 2003. "The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity." Econometrica. 71(6): 1695-1725.
Mussa, Michael. 1986. "Nominal Exchange Rate Regimes and the Behavior of Real Exchange Rates." Carnegie-Rochester Series on Public Policy, 25: 117-214.
Nakamura, Emi and Dawit Zerom. 2010. "Accounting for Incomplete Pass-through." Review of Economic Studies. 77(3): 1192-1230.
Prescott, Edward. 1997. "Needed: a theory of total factor productivity." Staff Report 242, Federal Reserve Bank of Minneapolis.

EconomicDynamics Interviews Steven Davis on Labor Market Dynamics

Steven J. Davis is the William H. Abbott Professor of International Business and Economics at the University of Chicago Booth School of Business. His interests cover employment outcomes, worker mobility, job loss, business dynamics, economic fluctuations, and national economic performance. He is also the editor of the American Economic Journal: Macroeconomics. Davis's RePEc/IDEAS entry.
EconomicDynamics: You have studied labor markets flows in the US extensively for a long time. In particular, you have identified regularities in job loss and job finding rates in recessions and recoveries. Is the recent recession looking similar to previous ones?
Steven Davis: In terms of labor market flows, the recent recession began much like previous US downturns: sharp spikes in job destruction, layoffs and the flow of job losers into unemployment plus a slow down in job creation, a drop in quits and a decline in the job-finding rate for unemployed workers. An important distinguishing feature of the recent downturn -- apart from its severity -- is the long, deep slide in the job-finding rate and its failure to rebound.

As measured by the unemployment escape rate in the Current Population Survey, the job-finding rate has ranged from 19-23% per month since the middle of 2009. This is about half the rate from 2004 to 2007, and much lower than job-finding rates in previous US recessions. Quit rates also dropped dramatically relative to pre-recession levels. By these metrics, the US labor market has become much less fluid since the onset of the recent recession.

Employer-side measures of labor market flows tell a consistent story. They also suggest that recent developments have accentuated a secular decline in the fluidity of U.S. labor markets. Gross job creation rates in the BLS Business Employment Dynamics data are about 25% smaller in recent quarters than in the early 1990s. A similar downward drift since the early 1990s shows up in the rate at which businesses hire new employees. See my working paper with Jason Faberman and John Haltiwanger on "Labor Market Flows in the Cross Section and over Time." Some of my other papers show that the rate of job reallocation across employers has been drifting down since the early 1980s, and since the late 1960s in the manufacturing sector.

ED: The unemployment rate in the US has doubled during the last recession, while the change has been much smaller in Europe. How can such a difference be explained?
SD: This is a great question but not one that I have studied carefully. An obvious point is that the United States entered the recession with a lower unemployment rate than most European countries. Still, even in terms of the additive change in the unemployment rate since 2007 or 2008, the United States fares poorly in comparison to many European countries.

The contrast to Germany is particularly striking. According to OECD statistics, the German unemployment rate fell from 8.4% in 2007 to 6.8% in the six months through September 2010. The US unemployment rate rose by 5 percentage points over the same period. Several factors are in play here, but it is worth stressing that Germany and the United States experienced similar output growth over this period, with a somewhat deeper contraction in Germany followed by a somewhat stronger recovery in 2010. So the main source of the contrasting unemployment experiences does not rest on differences in output growth.

Public subsidies for short-time working arrangements muted German job losses in response to the recession. To my mind, these subsidy programs raise several important questions: First, how large a role did they play in stemming the rise of unemployment in Germany (and several other countries)? Second, under what circumstances are subsidies for short-time arrangements preferable to a US-style unemployment insurance program? Third, to what extent do short-time arrangements retard the productivity-enhancing reallocation of jobs, workers and capital? Fourth, will short-time subsidies be unwound in a timely manner, or will they evolve into a semi-permanent subsidy to employment and production in weak and declining sectors? The answer to the last question may turn on institutional and political factors that differ across countries.

While the role of short-time arrangements in US-European unemployment comparisons warrants careful study, there remains the big question of why job creation and hiring have failed to rebound more strongly in the United States. I have not seen a convincing analysis of this question. I suspect that many factors are working in the same direction: a diminished capacity and appetite for risk bearing as continuing legacies of the financial crisis; high levels of uncertainty about future taxes, business regulations, and the implementation of recent health care legislation; an expensive fiscal stimulus program that was not well designed to promote employment; and a monetary authority that has exhausted its capacity to push down short-term interest rates.

ED: Over the last decades, the volatility of GDP and the probability of job loss both decreased. They both increased significantly in this recession. Is there a link?
SD: Yes, I think there is a strong and rather straightforward link. To see why, consider a simple model in which individual employers are hit by common and idiosyncratic shocks to employment growth rates. The common shocks include technology shifts, tax code changes, monetary policy innovations, commodity supply disruptions, and so on. For simplicity, suppose the shocks are mutually uncorrelated. Now make two key assumptions: First, employers differ in their loadings on the common shocks, i.e., in their response coefficients. Second, the average cross-product of the employer-specific loadings is positive for each common shock. The first assumption has abundant empirical support. The second captures the well-known fact that aggregate fluctuations exhibit much positive co-movement across sectors, regions and firms.

Now calculate the time-series variance of the aggregate employment growth rate and the cross-sectional mean of the employer-specific growth rate variances. These and related measures appear in empirical studies of aggregate and firm-level volatility. Given my two key assumptions, it is easy to show that the aggregate and firm-level volatility measures move in the same direction in response to a change in any one of the shock variances, provided that the employment shares and loadings are reasonably stable over time. Thus, for example, fewer commodity supply disruptions ("good luck") or smaller monetary policy innovations ("better policy") lead to declines in both aggregate and firm-level volatility.

My paper with several collaborators in the 2006 NBER Macroeconomics Annual sets forth this argument. We also show that the firm-level volatility of employment growth rates trended down from the early 1980s to 2001, in line with the declines in aggregate volatility stressed by the Great Moderation literature. The trend declines in firm volatility hold in every major industry sector of the US economy. My short paper on "The Decline of Job Loss and Why It Matters" considers several measures of job loss and shows that all of them trended downward during the Great Moderation period.

Getting back to the recent recession, high job-loss rates are one manifestation of high aggregate and firm-level volatility. When big negative shocks hit the economy, there is an increase in the volatility and cross-sectional dispersion of firm-level outcomes, and in job destruction and layoff rates. Big positive shocks can also raise volatility and dispersion, but they seem to occur less frequently or abruptly than big negative shocks. More important, it is much easier for workers to move between jobs with no intervening unemployment spell, or a relatively short one, in a booming economy.

ED: Labor market flow research has focused on the study of worker transitions. Only recently have flows on the establishment side been analyzed. Can we look at vacancies in a symmetric way to unemployment?
SD: Actually, research on employer-side flows goes back a long ways. Sumner Schlichter's 1921 book on The Turnover of Factory Labor and Wladimir Woytinsky's 1942 report on Three Aspects of Labor Market Dynamics are major early contributions. They remain well worth reading today. Katharine Abraham and others did important early work on job vacancies. And there is my work with Haltiwanger and Scott Schuh on job flows and much related work by others. There is also a great deal of interesting research on labor market flows in other countries, some of which exploits data on job vacancies.

Still, it is true that employer-side measures of vacancies and worker flows have received comparatively little attention. That has begun to change, partly because of new data on job vacancies and establishment-side measures of hires, layoffs and quits in the BLS Job Openings and Labor Turnover Survey (JOLTS). The JOLTS has been in production mode since December 2000, and it has been an eventful decade.

Faberman, Haltiwanger and I have begun to explore the relationship between job vacancies and new hires using JOLTS micro data. Our paper on "The Establishment-Level Behavior of Vacancies and Hiring" uses a simple model of daily hiring dynamics to identify the job-filling rate for vacant positions. The job-filling rate is the employer counterpart to the much-studied job-finding rate for unemployed workers. Textbook search and matching theories and standard matching function have strong implications for the behavior of the job-filling rate. These implications have not received much attention in previous research.

ED: This year's Nobel Prize in Economics was attributed to pioneers of search theory, in particular in how it applies to the labor market. How has this theory helped us in understanding labor market flows?
SD: Theories of search and matching provide an explicit, coherent framework for analyzing labor market flows and their relationship to frictional unemployment. There are many excellent contributions in this area, and I will mention only a few.

In their 1989 article on "The Beveridge Curve," Olivier Blanchard and Peter Diamond use concepts from search and matching theory to organize their influential study of job flows, worker flows, unemployment and vacancies. Dale Mortensen and Chris Pissarides develop an equilibrium search theory of frictional unemployment in their famous 1994 paper on "Job Creation and Job Destruction in the Theory of Unemployment." They use the theory to analyze the effects of aggregate and idiosyncratic shocks on job flows, vacancies and unemployment. In his 2005 AER paper, Rob Shimer shows that a closely related theory cannot readily account for the observed magnitudes of fluctuations in unemployment, vacancies and job-finding rates when wages are determined by a generalized Nash bargain. Shimer, Bob Hall and others have followed up on this observation in an active line of research on how wage-setting behavior affects hiring incentives and unemployment dynamics. In contrast to the focus on job creation and hiring incentives in the recent work by Hall and Shimer, Lars Ljungqvist and Tom Sargent put the spotlight on the incentives and skill evolution process of unemployed workers. See, for example, their 1998 JPE paper on "The European Unemployment Dilemma." Michael Pries and Richard Rogerson use search theory to analyze the role of firing costs and wage compression in persistent US-European differences in unemployment durations, hiring incentives and labor market flows. See their 2005 JPE paper.

ED: And can our recent understanding of the labor market dynamics data fashion theory?
SD: Yes, definitely. Let me give you some examples drawn from my recent research. In our 2010 AEJ-Macro article, my coauthors and I show that secular declines in business volatility (measured various ways) account for much of the large decline in US unemployment flows and unemployment rates in the period from the early 1980s to the mid 2000s. A natural way to explain this finding with search models is to allow for a decline over time in the variance of idiosyncratic match-specific shocks. The evidence in our AEJ-Macro paper should encourage researchers to model the idiosyncratic shock variance as a time-varying object, especially in quantitative studies of labor market flows and frictional unemployment.

My second example draws on recent work with Faberman and Haltiwanger. As I mentioned above, we use JOLTS data to recover the job-filling rate for vacant positions. We proceed to show that the job-filling rate rises very strongly with the gross hires rate in the cross section. As we discuss, the textbook equilibrium search theory of unemployment cannot replicate this finding. Surprisingly, this statement holds even when one extends the theory to incorporate variable recruiting intensity by employers with vacancies.

One way to reconcile the theory with the behavior of job-filling rates is to allow for variable recruiting intensity AND to drop the standard free-entry condition for job creation. The standard entry condition ensures that vacancies have zero asset value in equilibrium. Most search theories adopt this assumption because it simplifies the analysis of equilibrium. Our evidence indicates that the simplification comes at a fairly high cost. Another way to reconcile theory and evidence is to drop the random matching assumption in favor of directed search with wage posting. Directed search models can readily produce a positive relationship between job-filling rates and gross hires rates, as shown by Leo Kaas and Philipp Kircher in a recent working paper titled "Efficient Firm Dynamics in a Frictional Labor Market."

My third example also draws on work with Faberman and Haltiwanger. We consider a generalized matching function with three arguments: unemployed workers, vacant job positions, and recruiting intensity per vacancy. When interpreted through the lens of this function, our evidence on job-filling rates implies that the standard matching function under predicts hires in a weak labor market and over predicts hires in a strong labor market. That is exactly the pattern we see in the ten-year period covered by JOLTS data. We proceed to use our micro-based evidence to put structure on the generalized matching function and to develop an index for recruiting intensity per vacancy. We think these objects will be useful in helping to guide future theoretical developments.

References

Abraham, Katharine, 1987. "Help-Wanted Advertising, Job Vacancies, and Unemployment," Brookings Papers on Economic Activity, The Brookings Institution, vol. 18(1987-1), pages 207-248.
Blanchard, Oliver and Peter Diamond, 1989. "The Beveridge Curve," Brookings Papers on Economic Activity, The Brookings Institution, vol. 20(1989-1), pages 1-76.
Davis, Steven, 2008. "The Decline of Job Loss and Why It Matters," American Economic Review, American Economic Association, vol. 98(2), pages 263-67.
Davis, Steven, Jason Faberman and John Haltiwanger, 2010. "Labor Market Flows in the Cross Section and over Time." Manuscript, University of Chicago.
Davis, Steven, Jason Faberman and John Haltiwanger, 2009. "The Establishment-Level Behavior of Vacancies and Hiring," NBER Working Paper 16265, National Bureau of Economic Research.
Davis, Steven, Jason Faberman, John Haltiwanger, Ron Jarmin and Javier Miranda, 2010. "Business Volatility, Job Destruction, and Unemployment," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(2), pages 259-87.
Davis, Steven, John Haltiwanger and Ron Jarmin, 2007. "Volatility and Dispersion in Business Growth Rates: Publicly Traded versus Privately Held Firms," NBER in: NBER Macroeconomics Annual 2006, Volume 21, pages 107-180 National Bureau of Economic Research, Inc.
Davis, Steven, John Haltiwanger and Scott Schuh, 1998. Job Creation and Destruction, MIT Press, Cambridge MA.
Hall, Robert, 2005. "Employment Fluctuations with Equilibrium Wage Stickiness," American Economic Review, American Economic Association, vol. 95(1), pages 50-65.
Kaas, Leo and Philipp Kircher, 2010. "Efficient Firm Dynamics in a Frictional Labor Market." Manuscript, University of Konstanz.
Ljungqvist, Lars and Thomas Sargent, 1998. "The European Unemployment Dilemma," Journal of Political Economy, University of Chicago Press, vol. 106(3), pages 514-550.
Mortensen, Dale and Christopher Pissarides, 1994. "Job Creation and Job Destruction in the Theory of Unemployment," Review of Economic Studies, Blackwell Publishing, vol. 61(3), pages 397-415.
Pries, Michael and Richard Rogerson, 2005. "Hiring Policies, Labor Market Institutions, and Labor Market Flows," Journal of Political Economy, University of Chicago Press, vol. 113(4), pages 811-839.
Schlichter, Sumner, 1921. The Turnover of Factory Labor. New York. Schulz.
Shimer, Robert, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, vol. 95(1), pages 25-49.
Woytinsky, Wladimir, 1942. Three Aspects of Labor Market Dynamics. Committee on Social Security, Social Science Coucil. Washington DC.

Society for Economic Dynamics: Letter from the President

Dear SED Members and Friends:

Our 2010 summer meeting in Montréal, Canada, was a big success and the Society is grateful to the many individuals whose hard work helped to ensure this success. Our thanks go out specifically to the program chairs, Mark Aguiar and Michèle Tertilt, and the local organizers, Rui Castro and Francisco Ruge-Murcia.

The 2011 meeting of the SED will be held in Ghent, Belgium, from July 7-9. Cristina Arellano and Philipp Kircher have agreed to serve as program chairs, and have already arranged for an outstanding slate of speakers plenary--Robert Barro from Harvard University, Douglas Gale from New York University, and John Kennan from the University of Wisconsin. The local coordinators for the conference are Gert Peersman, Stijn Van Nieuwerburgh and Robert Kollmann. They are working hard to bring about another very successful meeting.

The 2012 meetings will be held in Cyprus. The team of local organizers includes Sofronis Clerides, Andros Kourtellos, Alex Michaelides, Chris Pissarides and Marios Zachariadis.

I would also like to take this opportunity to congratulate two long-time members of the Society--Dale Mortensen and Chris Pissarides--two of this year's recipients of the Nobel Prize in Economics. Both have been very active in the Society over the years, with each having been plenary speakers at earlier annual meetings, Dale having previously served as President and being one of the founding members of the Society, and as just noted above, Chris being one of the local organizers for the 2012 meetings in Cyprus. The research agenda that they initiated has long figured very prominently in the research presented at the annual meetings.

Lastly, I would like to take this opportunity to thank some additional individuals for their service to the Society. First, I would like to thank Robert Lucas and Ed Prescott for their repeated willingness to participate in pre-conference events that play a large role in ensuring adequate funding for the annual meetings. Second, I would like to thank Gianluca Violante for his service as editor of RED. Finally, I would like to thank Ellen McGrattan and Christian Zimmermann, for their years of hard work as Treasurer and Secretary of the Society, respectively.

See you all in Ghent!

Best Regards.

Richard Rogerson, President
Society for Economic Dynamics

Society for Economic Dynamics: Call for Papers, 2011 Meeting

The next annual meeting of the Society of Economic Dynamics will take place in Ghent, Belgium, from 7-9 July 2011. We are glad to announce keynote speeches by

Robert Barro, Harvard University
Douglas Gale, New York University
John Kennan, University of Wisconsin

You can now submit your paper for the conference using ConferenceMaker until February 15th, 2011. We are looking forward to many exciting submissions for the academic program!

Local information on Ghent including ease of transportation and local recreation have been compiled by the local organizers. All information on the conference can be accessed from the SED homepage.

We hope to see you next year in Ghent. Best wishes,

Cristina Arellano and Philipp Kircher
2011 SED Program Chairs

Mini-Conference Call for Papers: Misallocation and Productivity

The Review of Economic Dynamics is organizing a mini-conference on misallocation and productivity within the 2011 SED Meetings which will take place in Gent (Belgium) from 7 - 9 July 2011. Papers for the mini-conference are selected by Diego Restuccia of the University of Toronto and Richard Rogerson of Arizona State University. Submissions to the miniconference must be submitted simultaneously to the Review of Economic Dynamics for possible publication in a special issue of the journal. The deadline for submissions is February 15, 2011.

The organizers welcome submissions on the general theme of Misallocation and Productivity. Recent work in many different settings has suggested that productive resources are often not efficiently allocated across establishments. Moreover, the extent of this misallocation varies significantly across countries, and its effects on various aggregate outcomes and welfare can be substantial. Contexts of interest include, but are not limited to: macro, development, trade, labor, finance, and industrial organization. Topics of interest include, but are not limited to: (1) Measuring the degree of misallocation. (2) Isolating the underlying sources of misallocation. (3) Assessing the consequences of misallocation for allocations and welfare.

Submissions to the mini-conference will be handled through the general submission process for the 2011 SED conference in Gent. To submit a paper to the mini-conference, please log into ConferenceMaker conference submission website, upload your paper and abstract and make sure to select the area RED Mini-conference. Next, proceed to the Review of Economic Dynamics submission website to submit the paper there as well. When you submit to the Review of Economic Dynamics, you must enclose a cover letter stating that the submission is intended for the RED Special Issue on "Misallocation and Productivity" and that your paper is not already submitted anywhere else.

Remark: Papers submitted to the mini-conference that do not make it onto the miniconference program will automatically be reconsidered for the overall SED program. It is therefore not necessary (and it is not possible) to submit the same paper twice in ConferenceMaker.

Book Review: Kocherlakota's New Dynamic Public Finance

The New Dynamic Public Finance
by Narayana Kocherlakota

"New Dynamic Public Finance" is a term Narayana Kocherlakota coined for a plenary talk given at the 2004 Society for Economic Dynamics meeting, and the term stuck. It describes a theory of taxation that takes minimal restrictions on the instruments available for tax design and takes explicitly into account various uncertainties people face. It is therefore inherently forward-looking. Also, this theory is normative as it does not seek to understand why our current tax system is like it is.

The book is based on a series of lectures given in Toulouse that can be thought of as a graduate course on the topic. Thus, this supposes knowledge of dynamic methods in macroeconomics and is really appropriate as a second year PhD course or beyond. Beyond theory, it covers also some numerical applications of the theory. The research agenda is ambitious, and so are the implementations that sooner or later have to get down to concrete numbers.

The material is rather technical, but the reader who wants to just explore the topic should not be put off by this. Kocherlakota is careful to offer plenty of intuition along the way. The book starts with the classic Ramsey approach and shows how it may become problematic. Before expanding on it, some dynamic social contract theory is introduced. The core of the book is about dynamic optimal taxation and its various applications, in particular how the reciprocal Euler equation is important to characterize equilibria with private information where the standard Euler equation fails. The theory is then applied to two-period, infinitively-lived and overlapping-generation econonomies. The latter has become quite relevant as it allows to study intergenerational transfers and bequests and how taxes influences them. The book concludes with suggestions for further research.

The New Dynamic Public Finance was published in July 2010 by Princeton University Press.

Impressum

The EconomicDynamics Newsletter is a free supplement to the Review of Economic Dynamics (RED). It is distributed through the EconomicDynamics mailing list and archived at http://www.EconomicDynamics.org/newsletter/. The responsible editors are Christian Zimmermann (RED associate editor) and Giovanni Luca Violante (RED coordinating editor).

The EconomicDynamics Newsletter is published twice a year in April and November.

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