The Fall and Rise and Fall Again of the Baltic States

BY EDWARD LUCAS | JUNE 22, 2009

But 20 years ago, when I first visited what were then still the Soviet Baltic republics, the current problems would have seemed an almost inconceivably desirable state of affairs. The Baltic states, for almost all intents and purposes, had ceased to exist to the outside world for nearly half a century. As a youngster in Britain in the 1970s, I had read of Estonia, Latvia, and Lithuania as one might read about the mythical land of Atlantis—a fabled place of the distant past, submerged by an unimaginable catastrophe. In the early 1980s, I huddled with demonstrators in London, their banners reading, "Estonians out of Siberia! Soviets out of Estonia!" It was hard to know which seemed less likely. In London, I met elderly, dignified survivors of the Baltic lost world in dusty rooms that reeked of irrelevance and desperation. Even just visiting the Baltic states during their years of Soviet rule was near impossible.

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Welcome to Baltland
How the Balts differ, and why it matters. By Edward Lucas

Then came the small miracle of the 1990s. When I lived in the Baltic states for the final two years of the Soviet era, I did not just discover Atlantis: I watched it rise out of the sea and join the United Nations. As the editor of the English-language weekly The Baltic Independent, I chronicled what happened next: how the reborn republics cleaved to the West, shrugging off the economic and political legacy of the occupation.

Today, Atlantis is buffeted again by cruel and threatening tides. One is the sharp downturn in the domestic Baltic economies, which began two years ago when their reckless credit bubbles began popping. These had been inflated by the belief that the Baltic markets were rapidly converging with Europe’s. Property prices and consumer spending rocketed, creating huge current account deficits as Estonians, Latvians, and Lithuanians took advantage of the easy credit offered by banks keen to increase their market share in Europe’s most dynamic new region. Square foot for square foot, prime apartments in the Baltic capitals were costlier than in Copenhagen.

On top of all that has now crashed an even larger wave: the global recession. As small, open economies, the Baltic states thrive when their neighbors are booming, and wither when they slump. In the current downturn, demand for Baltic products—food, furniture, tourism—is sinking both in European markets and in Russia. That has led to stunning gdp falls in all three countries. In the first quarter of 2009 alone, gdp dropped at a 12 percent annual rate in Lithuania, 15 percent in Estonia, and 18 percent in Latvia. Forced to accept an imf-led bailout in December, Latvia is now struggling to meet its loan conditions. Public-sector salaries there were cut by at least 20 percent. Discretionary public spending is to fall 40 percent.

A third crashing tide is geopolitics. Russia looms next door to the Baltic states as a contemptuous and even hostile neighbor that has played out repeated military exercises based on the scenario of reconquest. The three Baltic states are today members of nato but often feel they are on its margins: in the alliance on paper, but lacking the contingency planning and military presence that would bolster the security guarantee provided by Article V of the nato treaty. Russia’s increasingly angry rhetoric and ominous moves may seem like empty posturing from the safety of Brussels or Washington, but from a Baltic standpoint they are threatening—and all the more so for having thus far prompted no clear Western response.

It used to be Belgium that was counted as the "cockpit of Europe”—the place where great-power interests clashed and were settled. Now it is the Baltic states. At stake is not just nato’s credibility, but also that of the whole post-communist experiment: Is it possible for small countries on Russia’s borders to gain durable prosperity, security, and freedom, with their destiny determined by their own talents and virtues? Or will the ebb and flow of economic fortune ultimately prove that these small states are unsustainable as anything but satrapies for more powerful neighbors?

To answer those questions, one has to start with the past. For though the Baltic states share flat landscapes and culinary quirks (herring for breakfast, potatoes for lunch and dinner), what they really have in common is their tragic recent history.

For each Baltic state, Soviet rule effectively brought a cultural revolution. National elites were murdered or exiled. Hundreds of thousands were deported, executed, or starved to death. Collectivization destroyed the peasant farms that had been the backbone of Baltic economies and societies. Finally came the suffocation of national identity through mass immigration of Russian-speakers from other parts of the Soviet Union and the purging of books that might portray the era of Baltic independence in favorable terms. Estonia’s leading novelist, the late Jaan Kross, remembered watching books from his country’s main university library destroyed by an ax-wielding apparatchik.

What particularly aroused Russian ire (and still does) was that after the 1940-1941 Soviet occupation, Estonians and Latvians did not see the prospect of another one as "liberation." Indeed, from 1944 onward, many Baltic citizens fought hard against Soviet forces, even shoulder to shoulder with the Nazis at times. The bad blood still lingers, as seen two years ago when Estonia (or eSStonia, as Russian propagandists still call it) decided to relocate a Soviet war memorial from the center of Tallinn to a military cemetery on the outskirts of town. For Russians, the bronze statue was "Alyosha the Liberator”; for Estonians, it was "The Unknown Rapist." The result was a fierce diplomatic spat, the besieging of the Estonian Embassy in Moscow, and a mammoth cyberattack that briefly disrupted public services.

The bleakness of life inside the Baltic states during the occupation era was matched by overseas apathy, even hostility, toward their fate. Britain handed over to the Kremlin the Baltic gold reserves, which had been entrusted to the Bank of England for safekeeping. Dusty embassies in Washington and elsewhere maintained the vestiges of legal existence, and a dwindling band of elderly Baltic diplomats would gather for occasional meetings at the U.S. State Department, where their flags still hung in the lobby. It was a good way to annoy the Kremlin, but the cause of Baltic independence was all but dead. Those who persisted in raising it were seen as eccentric, out of touch, and irrelevant. Czeslaw Milosz, the Polish émigré poet and Nobel Prize winner, wrote in his seminal work on totalitarianism, The Captive Mind, that he could not stop thinking about the Baltic states, which he described as being "boiled down" in a pot with a "tightly closed lid." But he also said that others regarded his preoccupation as the epitome of futility: It would waste his life and awake the "wrath of Zeus."

After regaining independence in the early 1990s, the Baltic countries could easily have turned out like Moldova: semifailed states on Europe’s periphery, corrupt, geopolitically hamstrung, and surviving on remittances. Their foreign trade was entirely tied to the collapsed Soviet economy. They had no independent institutions and no civil servants capable of running a modern state. Their politicians were a mix of wily but untrustworthy Soviet holdovers, unworldly professors (Lithuania’s first post-Soviet president, Vytautas Landsbergis, was a musicologist), and inexperienced youngsters (Juri Luik, Estonia’s representative to nato, entered high office at 26). All the while, the kgb used its cash, connections, and intimate knowledge of "the lives of others" to preserve and expand its influence—a task made easier by the unsolved question of how to deal with the hundreds of thousands of Soviet-era migrants and their descendants.

That combination of problems meant that few saw the Baltic states as future members of serious Western clubs. They were too flaky for the European Union, too geopolitically sensitive for nato, and too poor for the oecd. And many in the West told them so. As the Cold War wound down, Baltic leaders aspiring to independence received not warm words of encouragement from the West, but rebukes. Why were they so impatient? Why were they impeding Soviet leader Mikhail Gorbachev’s reforms with their hard-line nationalism? A Finnish official even told me once that Estonian independence would be an economic and political disaster that would prove a "catastrophe”—for Finland! Such points went down badly in the Baltics, and not surprisingly. It was akin to telling a prisoner to consider his captors’ feelings, rather than trying to escape.

So how did the Baltic countries do it, succeeding so brilliantly and so quickly? Part of it was luck: Russia was weak, and its potential for mischief was initially quite limited. In addition, the Baltic diasporas provided a serendipitous assortment of unlikely leaders. Lithuania’s president, Valdas Adamkus, spent most of his life as a civil servant in the U.S. Environmental Protection Agency. His Estonian counterpart, Toomas Hendrik Ilves, was raised in the United States and educated at Columbia University. Former Latvian President Vaira Vike-Freiberga spent most of her life in Canada as a psychology professor. Hundreds of lesser-known others in the 1990s helped rebuild everything from the diplomatic service to business.

But the biggest reason for the success of the Baltic states was good policymaking, usually introduced first in Estonia and then copied by the other two. In barely two years, from 1992 to 1994, the radical reforming Estonian government of Mart Laar introduced a flat tax, privatized most national industry in transparent public tenders, abolished tariffs and subsidies, stabilized the economy, balanced the budget, and perhaps most crucially, restored the prewar kroon and pegged it to the rock-solid deutsche mark. As a result, Estonia became one of the most open and transparent economies in Europe, and with growth came political stability: Russian troops left the Baltic region by 1994, fears of Balkan-style ethnic conflicts receded, and Soviet noncitizens in Estonia and Latvia began to assimilate.

Competitive advantage began to emerge. The first business to boom was transit. Then, though the Baltic states had practically no indigenous metallurgical industry, they became major players in the metals trade. Next came manufacturing, thanks to outsourcing from old Europe. Foreign investment poured in, and with it technology and know-how. Productivity soared, and tourism took off, as foreigners discovered the chocolate-box charms of Tallinn, the vistas of Jugendstil buildings in Riga, and the baroque splendors of Vilnius.

Estonia did particularly well. High-tech companies set up there and became some of the country’s largest employers. Estonian geeks in 2002 invented Skype, a peer-to-peer Internet telephony software that now has more than 400 million users worldwide. The state also pioneered "e-government," the idea of putting public administration online. At a time when these innovations were unheard of elsewhere in Europe, Estonians could file their taxes on the Internet, vote electronically, and even watch a live Webcast of their prime minister’s official waiting room. Visitors the world over came to study the Estonian model of flat taxes, lean government, and rapid innovation, which inspired no little envy among Lithuanians and Latvians, not to mention resentment from the Russians next door.

As the new millennium dawned, Atlantis was back in business, free and democratic. But it was not secure. That seemed to change in 2004, when after frustrating false starts and Western foot-dragging the Baltic states gained membership in the European Union and nato. The change was partly nominal. The states passed huge lumps of eu regulation into law, often with only cursory scrutiny of their implementation. nato, for its part, fudged the question of whether it would really be willing to defend its new Baltic frontiers against Russia. The alliance’s presence to this day in the Baltic states consists of a small squadron of fighter planes, provided by other countries on a rotating basis.

Still, the Baltic states seemed set for their happiest period ever. They were useful allies, the epitome of post-communist success, and an integral part of the Euro-atlantic world. They were secure and prosperous as never before. And they had begun to lose the "ex-Soviet" label; that was for basket cases like Georgia and Ukraine.

It took the collapse of the Latvian government in February, amid fevered speculation about devaluation and political unrest, to bring the Baltic states’ problems to the world's attention. Signs of trouble had been visible much earlier, however. For those who knew the countries well, the sense of hubris in the years of the post-2004 boom was almost stifling. Growth in Latvia, for example, was an unsustainable, debt-fueled 11.9 percent in 2006 and 10.2 percent in 2007. Current account deficits—a good sign of how far beyond its means a country is living—soared too, reaching nearly 25 percent of gdp. That made all three countries completely dependent on outsiders’ willingness to keep lending them money. As upsets elsewhere in Europe from Iceland to Ireland have proved, the trouble with this model is that borrowing money is easy when you don’t need it, but difficult when you do. In past years, the inflows inflated the bubble. Now, national survival depends on the willingness of Swedish taxpayers to guarantee banks that so unwisely overextended themselves.

The boom years in the Baltics—as in so many other fast-growing emerging markets—turned out to have been wasted. Instead of firmly applying the brakes, running large budget surpluses, tightening control of the banking system, and taking urgent action to preserve competitiveness, politicians harvested the proceeds and ignored the risks, thinking that the growth was the result of their own good decisions. Calls for caution were brushed aside. Rather, the impulse was, as Latvian tycoon-turned-politician Ainars Slesers put it, to "put the pedal on the metal."

The detrimental effects of this mentality were clear. A tight labor market sent standards in service industries plunging. At the region’s premier security thinkfest, the Lennart Meri Conference in Estonia in 2007, startled delegates turned up for breakfast on Sunday morning at Tallinn’s Radisson hotel to find that nothing was on offer. The staff simply hadn’t turned up; the manager shrugged, "Who wants to work on a Sunday morning?" Foreign tourism operators began complaining. Once a bargain destination for those seeking a quick break, the Baltic states became pricey before they became good.

The smugness not only fueled the boom, but it allowed for the dodging of decisions on issues ranging from corruption and cronyism in politics to structural economic problems. In Latvia and Lithuania particularly, politics stank. Lithuanian President Rolandas Paksas was forced out of office in 2004 amid allegations of extortion and links with Russian organized crime. Another high-ranking Lithuanian politician, Viktor Uspaskich, fled to Russia when his bookkeeper turned over evidence to the authorities of serious breaches of party finance laws. Latvia was run by a bunch of party bosses with strong business ties, irreverently dubbed the "Politburo." On repeated occasions they tried to fire the heads of autonomous public bodies, such as the chief of the anticorruption authority, who had come dangerously close to uncovering how the country was run behind the scenes.

The first clear sign of trouble came when the one big bank in the region not owned by a foreign parent, Latvia’s Parex Bank, got into difficulties in mid-2008. Parex had always been a questionable success story. In the late 1990s the bank used to advertise on Russian television with a spot showing a $1 bill and the slogan "We are closer than America." The clear implication was that Parex was a convenient means for rich Russians to get their money out of the country. Parex strongly denies that it ever broke any Latvian law, and it has never been prosecuted. However, the bank has come under intense scrutiny from international officials seeking to combat money laundering.

Parex’s weakness was that its depositors were mainly offshore and highly mobile, while its lending had mostly been to construction projects inside Latvia, many of which soured simultaneously. After depositors withdrew nearly $430 million in the course of six weeks, the bank was nationalized in November for the token price of a couple of dollars. It also received a bailout in excess of $380 million from the Latvian state and the European Bank for Reconstruction and Development.

The incident dented Latvia's reputation hugely. The country's institutions had so far done an impressive job in seeming to insulate the running of the country from the political shenanigans of the elite. Now they had failed glaringly to supervise the country's best-known financial business, with near-catastrophic consequences. Latvia's financial weakness suddenly revealed the hollowness of past success.

The crisis has not spared Estonia and Lithuania either. A vivid illustration of that is the loss of air links with the outside world. Flying direct to Tallinn or Vilnius from main European destinations has become difficult or outright impossible. Estonia's national carrier, Estonian Air, has cut back its routes sharply. Lithuania's FlyLAL went bust amid an acrimonious dispute with the owner of the Vilnius airport, endangering the country's role as the intellectual and diplomatic hub of the Baltic. Also at risk is Lithuania's cherished prize—its yearlong celebration of the selection of Vilnius as the "European Capital of Culture" for 2009. Faced with a time-consuming and costly stopover in Copenhagen, Helsinki, or Frankfurt, many potential visitors may simply decide to stay away. Once again, the Baltic states feel they are fading from the map.

The three countries face this round of economic hardship with many important policy levers out of reach. The obvious step would be to devalue their currencies, but because they are guarded by the banks, that move would shake each country to its foundations while also bankrupting the many households and firms that have loans in euros and Swiss francs. The Baltic states have no room to relax monetary policy. Nor can they use fiscal policy to ease the pain—borrowing money to boost state spending—because all three countries are trying to meet the euro area's 3 percent budget deficit criterion.

Instead, the Baltic states are pushing through an "internal devaluation," cutting wages and pruning bureaucracy in the hope that these measures will boost their exports and attract renewed foreign investment. The sole cushion is money from the European Union and other international lenders. It could work. The three Baltic economies have already shown that they can turn on a dime. They did this in 1991 under far harder conditions and again in 1998, after the Russian financial crisis. Still, these austerity measures require extraordinary patience and a high tolerance for pain among voters who will see their living standards plunge for the next two years. It also requires Swedish and other foreign banks to stay the course on their bad loans, even as they will lose money hand over fist.

The big hope is that the crisis will prompt the reforms that Baltic politicians so smugly skipped during the boom years. It is a scandal, for example, that higher education in all three countries is so second-rate. At least one of their universities should have turned itself into a strong competitor for students and faculty frustrated with the lumbering state-run universities of old Europe. Health, transportation, local government, and criminal justice still retain striking levels of Soviet-style producer power, corruption, and inefficiency. Progress on these fronts would not just reassure voters that the state was doing its job properly—it would also encourage external lenders, such as the European Union, to help keep the Baltic states afloat. If none of this happens, though, the water level will just keep going up.

The Baltic states' current fate epitomizes the wider story in Eastern Europe, of half-baked reforms pursued with more enthusiasm than judgment. Looking back on the 20 years since the Berlin Wall fell, it is clear that the economic difficulties facing the former captive nations were overestimated. Solidarity leader Lech Walesa once said that turning a capitalist economy into a communist one was as easy as turning an aquarium into fish soup. The difficulty was reversing the process. In fact, creating a thriving capitalist system on the ruins of a planned economy has proved the easier part. The difficulty has been in building strong institutions with the political supervision necessary for them to stay healthy.

A prime example is the currency regimes: To create credibility, all three countries adopted strictly fixed exchange rates. These gained totemic significance: The central banks that administer the currency pegs to the euro are the most trusted institutions in each country. Yet by 2004, it would have been far better to have the exchange rates more flexible. A revaluation in the boom years would have cooled overheating; a devaluation now would stave off hypothermia.

The big question today is whether the Baltic states' extraordinary flexibility and determination will allow them to recover as quickly as they toppled. The danger is twofold. One is that the critical mass of patriotism and solidarity that helped them overcome past difficulties has dissipated. The most able people have another choice now: They can leave. Of my most impressive Baltic friends, one is married to a Dutch diplomat and lives in Asia; several have jobs in the comfortable bureaucracies of the European Union or nato. A sprinkling work in London or for multinational companies. When they see the mess back home, they are torn: Should they abandon their careers and return, or stay on the comfortable sidelines? The members of the Baltic diaspora, "who in their freedom had no homeland," had spent half a century waiting for the chance to help their cousins, "who in their homeland had no freedom," as the old toast goes. But it's unclear whether that romantic history will repeat itself. Undoing the consequences of foreign occupation was a lot more glamorous than unraveling the consequences of a property boom or haggling about swap arrangements with other central banks.

Second, the Baltic states' future is not just in their own hands. The economic crisis coincides with the rise of a resurgent, revanchist Russia and its alliances with a divided and demoralized Europe. The most threatening prospect for Estonians, Latvians, and Lithuanians is the "Schroederization" of German foreign policy—derived from former Chancellor Gerhard Schroeder, whose conspicuous friendship with Russian leader Vladimir Putin while in office morphed into the chairmanship of a controversial Russian-German gas pipeline consortium within months of his stepping down. The Baltic states feel squeezed. Who will defend their economic and political interests when big countries once again make decisions over their heads?

Related

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Welcome to Baltland
How the Balts differ, and why it matters. By Edward Lucas

Those fears are a little overblown for now. Poland and Sweden are two European heavyweights determined to prevent a Russian-German axis from developing further. Russia's own economic problems have somewhat lessened its bilious outpourings against the Baltic states. Yet the danger remains. As unemployment rises and social strains increase, the risk of local Russian-speakers feeling victimized—or the indigenous populations blaming them—also increases. Russia has said on repeated occasions that it reserves the right to intervene, even militarily, to defend the (unspecified) interests of its "compatriots" elsewhere in the former Soviet Union. After the 2008 conflict in Georgia, few can doubt their resolve to do so. Russia is also passing a law that will make illegal any attempt to equate Hitler and Stalin, which will criminalize the Baltic states' own version of their history.

Russia can exert other kinds of leverage, too. Lithuania will be almost totally dependent on Russian gas, for example, when it has to close its nuclear power station at Ignalina at the end of the year. Latvia's lucrative east-west transit trade is one of the few bits of the economy that is still thriving. This creates potential for political pressure. Until the Baltic states have developed not only their economies but also their political institutions fully to Nordic levels, and completed their reintegration into the Western world, they will not be completely secure. And at present, the combination of a nationalist Russia and an economic downturn is alarming.

"We needed another 10 years," says Asta, one of my oldest Lithuanian friends. She's right. Atlantis rose from the depths. But the sea walls are still too low. And now the water is rising again.

Want to Know More?

• Edward Lucas’s book The New Cold War: Putin’s Russia and the Threat to the West (New York: Palgrave Macmillan, 2008) offers an in-depth look at the Baltics’ neighbor and former colonizer to the East. Lucas also blogs about the region at edwardlucas.blogspot.com.

• For a comprehensive history of the Baltic States from ancient times through the last century, read Anatol Lieven’s The Baltic Revolution (New Haven: Yale University Press, 1993). The Baltic States: Years of Independence: Estonia, Latvia, Lithuania, 1917-1940 (Georg von Rauch, New York: St. Martin’s Press, 1995) and The Baltic States: Years of Dependence, 1940-1990 (Romuald Misiunas and Rein Taagepera, Berkeley: University of California Press, 1993) together provide an integrated picture of Latvia, Lithuania, and Estonia’s survival through years of Russian colonialism, language discrimination, and nationalist struggles.

• For a literary depiction of the region, William Palmer’s The Good Republic (London: Secker & Warburg, 1990) vividly captures the journey of a Baltic emigrant returning with soon-shattered innocence to his homeland. The Captive Mind, by Czeslaw Milosz, poses moral dilemmas from the lives of those living under totalitarian regimes.

The savings glut. Controversy guaranteed.

Posted on Tuesday, June 30th, 2009

By bsetser

Few topics are quite as polarizing as the “savings glut.” The very term is often considered an attempt to shift responsibility for the current crisis away from the United States.

That is unfortunate. It is quite possible to believe that the buildup of vulnerabilities that led to the current crisis was a product both of a rise in savings in key emerging markets, a rise that — with more than a bit of help from emerging market governments — produced an unnatural uphill flow of capital from the emerging world to the advanced economies, and policy failures in the U.S. and Europe.

The savings glut argument was initially put forward to suggest that the United States’ external deficit was a natural response to a rise in savings in the emerging world – and thus to defuse concern about the sustainability of the United States’ large external deficit. But it was equally possible to conclude that the rise in savings in the emerging world reflected policy choices* in the emerging world that helped to maintain an uphill flow of capital – and thus that it wasn’t a natural result of fast growth in the emerging world. This, for example, is the perspective that Martin Wolf takes in his book Fixing Global Finance. Wolf consequently believed that borrowers and lenders alike needed to shift toward a more balanced system even before the current crisis.

From this point of view, the savings glut in the emerging world — as there never was much of a global glut, only a glut in some parts of the world — was in large part a result of product of policies that emerging market economies put in place when the global economy — clearly spurred by monetary and fiscal stimulus in the US — started to recover from the 2000-01 recession. China adopted policies that increased Chinese savings and restrained investment to try to keep the renminbi’s large real depreciation after 2002 – a depreciation that reflected the dollar’s depreciation – from leading to an unwanted rise in inflation. The governments of the oil-exporting economies opted to save most oil windfall – at least initially. Those policies intersected with distorted incentives in the US and European financial sector – the incentives that made private banks and shadow banks willing to take on the risk of lending to ever-more indebted households (a risk that most emerging market central banks didn’t want to take) to lay the foundation for trouble.

On one point, though, there really shouldn’t be much doubt: savings rates rose substantially in the emerging world from 2002 to 2007. Consider the following chart – which shows savings and investment in emerging Asia (developing Asia and the Asian NIEs) and the oil exporters (the Middle East and the Commonwealth of independent states) scaled to world GDP.

Investment in both regions was way up. But savings was up even more.

It is unusual for Asia and the oil exporters to show large surpluses at the same time. In 98 the fall in oil prices helped Asia and hurt the oil exporters; in 2000 the rise in oil prices helped the oil exporters and hurt Asia. And way back in 1980, Asia ran a deficit that helped offset the oil exporters’ surplus.

The main reason for the rise in emerging Asia’s savings is simple: China’s GDP rose relative to world GDP, and China’s savings rate rose relative to China’s GDP

The chart is from Stephen Green of StanChart; used with permission

The result was a very large increase in the aggregate savings of the emerging world – especially after 2003. The rise in the combined surplus of Asia and the oil exporters that followed the Asian crisis was around 0.5% of world GDP. The post 2003 “China boom” pushed the combined savings rate of the oil exporters and emerging Asia up another 1% of world GDP.

All my data, incidentally, comes straight from the IMF’s WEO data tables. All I did was to multiply the data on savings rates by regional GDPs and then scale the resulting dollar figure to world GDP in dollars.

That disaggregated data is almost as striking.

It shows, for one, that the “investment drought” argument applies far more to the Asian NIEs (Korea, Taiwan, Singapore, Hong Kong) than to the rest of Asia. Investment in some countries may not have recovered from the 1998 crisis, but the overall data is dominated by the huge rise investment in developing Asia (read China). Plotting the rise in billions of dollars – rather than as a share of global GDP – makes the scale of the rise in investment in developing Asia over the past few years clear.

Savings and investment in India both rose. And China went from a $1 trillion economy investing 30 to 35% of its GDP to a $4 trillion plus economy investing close over 40% of its GDP …

It is also striking that investment in the Middle East was essentially stagnant, in dollar terms, from say 1980 on. That meant that is was falling as a share of world GDP – and certainly falling relative to the Middle East’s population. Comparisons with the “boom” level of 1980 is a bit unfair, but it still isn’t hard to see why the region stagnated when oil prices stagnated.

And it also isn’t hard to see why the region boomed when oil prices soared, as the rise in oil revenue financed a boom in investment. The scale of that boom – in dollar terms – is rather impressive.

The net result: the global economy prior to the crisis was characterized both by high levels of both savings and investment in Asia and the oil exporters and by high levels of consumption and low levels of savings in the US.

In a global economy, a rise in savings relative to investment in one part of the world necessarily implies a fall in savings relative to investment in the rest of the world; sorting out why key macroeconomic variables change is always difficult.

Maybe this equilibrium was a function of excessive demand stimulus by the advanced economies in the aftermath of the last recession – and lax financial regulation that allowed households to over-borrow. High US and European demand allowed the emerging world to save more. Maybe it was a function of policies in the emerging economies, policies sometimes put in place to support undervalued exchange rates. That would explain why the growing US savings deficit didn’t put upward pressure on global interest rates and why the rise in the US external deficit didn’t lead to a rise in US real interest rates — something would have short-circuited the housing boom. Probably it was a mix of both. Emerging market savers (really their governments, as private savers weren’t exactly seeking out depreciating dollars) helped to provide Wall Street and the City the rope they (almost) used to hang themselves.

No matter. We don’t need to assign responsibility for the imbalances that marked the pre-crisis global economy to know that the chain of risk-taking that allowed emerging market savers to finance heavy borrowing by US households didn’t result in a stable system.

How the ECB’s fig leaf has completely withered away

Now that the global recession appears to have passed its low point, panicmongers in the media and financial markets are shifting their attention from deflation to inflation — and especially to the debasement of the dollar by the money-printing operations of the US Federal Reserve. Whether printing money necessarily always leads to inflation is a long-running theoretical debate which the economics profession shows no sign of resolving, there is a factual question related to this argument that is much more important and straightforward, yet completely misunderstood. Leaving aside the question of whether it is a good or a bad idea to print money, which of the world’s leading central banks is printing money faster: the Fed or the European Central Bank?

Last Wednesday, the European Central Bank injected €442 billion (£377 billion) of new cash into the euro money markets. This was the biggest long-term lending operation in the history of central banking and was equivalent to half the Fed’s entire monetary expansion in the past 18 months. Yet most people still believe that the Fed (along with the Bank of England) is engaged in a “reckless” experiment with inflationary quantitative easing (QE), while the ECB is steadfastly honouring the deflationist traditions of the Bundesbank’s “steady hand”.

The ECB Council debated for months about QE, the modern equivalent of “printing money”, since it involves the central bank creating money out of thin air by signing computer-generated promissory notes and then distributing these around the commercial banking system by using them to buy up government bonds. In the end, the ECB decided to print only €80 billion to buy on private sector bank bonds, in contrast to the $1 trillion (£606 billion) of bond purchases undertaken by the Fed. And even this trifling monetary expansion was ferociously attacked by Angela Merkel for threatening Europe’s inflation outlook and jeopardising the credit of the ECB.

However, if we look at the facts, the transatlantic difference is less clear. In fact, the ECB is printing money even faster than the Fed is.

It is also supporting fiscal policy more explicitly through debt monetisation and taking much bigger risks with its credibility and solvency. The first point is illustrated in the chart. Since mid-2007, central banks have expanded their total liabilities (the broadest definition of what it means to print money in the modern world) by $1.2 trillion in the US and by $1.5 trilllion in euroland. Given that GDP is 12 per cent bigger in the US than in the eurozone, this means that the ECB’s printing presses have actually been running 50 per cent faster than the Fed’s. Someone should point this out to Mrs Merkel: since the ECB presses were presumably made in Germany, it would give her something else to boast about.

Meanwhile, we can move on to a second surprising comparison between the European and US central banks: their willingness to monetise government debts.

Having established that the scale of the money-printing operation has actually been bigger in Europe than in America, the next step is to compare the methods used by the Fed and the ECB to achieve these expansions. On this point, consensus opinion is even clearer: the ECB is almost universally seen as more “prudent” in the way it has expanded its balance sheet. The Fed has been buying government and agency bonds outright, thereby exposing itself to the risk of capital losses from rising interest rates, which in turn could potentially constrain its future monetary decisions. Even worse, the Fed’s willingness to buy Treasury bonds, at a time when the US Government’s deficits are exploding, means that it has taken the first step down the primrose path of debt monetisation that leads ultimately to Zimbabwe and Weimar. The ECB, by contrast, has not weakened its balance sheet with long-maturity bonds and dubious corporate assets and, most importantly, it has refused to buy government bonds or engage in debt monetisation.

This is the conventional wisdom, but again consider the facts. It is certainly true that the ECB has expanded its balance sheet almost entirely by lending money to the euro-area banks, while the Fed’s new lending has mostly been to the US Government and agencies. But does this really mean that the Fed has taken greater risks than the ECB or done more to facilitate profligate public borrowing? The answer to the question is a clear “no”. The ECB’s loans to eurozone banks at the latest count stood at $1.5 trillion — before accounting for last week’s €442 billion bonanza. Are these loans really as safe, or even safer, than the Fed’s $1.7 trillion of US Treasury and agency bonds? According to ECB apologists, its loans to the banks are completely safe because they are secured by collateral that can be sold if the borrowers default. But this reassuring claim disregards the massive reduction in the quality of collateral that the ECB has been accepting since the start of the credit crunch.

Unlike the Fed and the Bank of England, which only accept AAA public bonds as collateral for their lending operations, the ECB now lends against low-rated mortgage bonds, commercial loan books and other dubious assets that the markets would treat as “toxic” were it not for the ECB’s willingness to turn them into instant cash. The ECB has been praised for the boldness with which it has set aside the traditional rules of central banking in the crisis — and this is perfectly justifiable, but the ECB’s apologists cannot have it both ways. Those who praise the ECB for its “imaginative” response to the crisis must also acknowledge that it has accepted much greater credit risks than the Fed. Which brings us to the question of financing public debts.

The Fed has “monetised” roughly $1 trillion of US Government debt since 2007, if we combine its Treasury and agency bond buying. Meanwhile, the ECB has lent $1.5 trillion to the euro-area banks. But what have the euroland banks done with this new money? They have lent most of it straight to their governments. Indeed, the governments in Ireland, Greece, Portugal, Spain and Austria would long-since have gone bust had it not been for the willingness of the commercial banks in these struggling economies to buy unlimited quantities of government bonds with money borrowed from the ECB. And these bond purchases have, in turn, been used as collateral for more ECB borrowings, which could be used to buy more government bonds.

In effect, therefore, the ECB has been lending money by the shed-load to governments, with commercial banks acting merely as a fig leaf for what would otherwise be seen as a blatant monetisation of the most insolvent European countries’ public debt. In normal circumstances, this fig leaf might at least have theoretically protected the virginal purity of the ECB by interposing the commercial banks’ own balance sheets between the government borrowers and the ECB.

In normal circumstances, if the Greek Government defaulted, damaging the collateral deposited by Greek banks at the ECB, the losses would fall on the Greek banks, rather than the ECB, since commercial banks remain the beneficial owners of the collateral they deposit. But in today’s conditions, this Maginot Line between the credit problems of European governments and the ECB’s balance sheet is a joke, since the Greek, Irish and Spanish banks queuing up for ECB funding are near-insolvent and would certainly be insolvent were it not for the limitless supply of money they are getting, in exchange for dubious collateral, from the ECB itself. In short, the commercial bank intermediaries interposed between the ECB printing presses and European governments’ borrowings should not even be described as a fig leaf — more like the climactic G-string in the world’s most expensive strip show.

Conspicuous Consumption and Race: Who Spends More on What

Some groups, such as blacks and Hispanics, seem to spend more on such emblems of success than others. Or is that just a stereotype?

Comedian Bill Cosby has long condemned his own black community for spending too much on flashy goods at the expense of children's education. He has been roundly criticized by some and praised by others, but there hasn't been much evidence to show whether his claims are true. Those who believe spending patterns vary among racial and ethnic groups typically invoke cultural differences, but there hasn't been much solid evidence of that, either.

"Blacks do spend more on these things -- jewelry, clothing and cars -- that have something to do with visibility," says Wharton finance professor Nikolai Roussanov. "Is it just taste? Or does it have to do with a social status component?"

Economists have long accepted the explanation for conspicuous consumption presented by Norwegian-American economist Thorstein Veblen, who coined the term at the end of the 19^th century. Valuable possessions visible to all are a signal of one's wealth, success and status, Veblen said. Today, most people recognize that spending decisions are influenced by the desire to "keep up with the Joneses."

In looking deeper at the subject, Roussanov and his collaborators, Kerwin Kofi Charles and Erik Hurst of the University of Chicago, found some truth to the ethnic stereotypes on spending, but they concluded that the explanation lies in economics, not culture. Their work is described in a paper titled, "Conspicuous Consumption and Race."

"If you're a middle-class black, it seems like in order to be perceived by whites and other blacks as relatively well off, you have to show you have money," Roussanov says. "You have to spend more on things that are observable."

To examine spending by racial groups, Roussanov and his colleagues studied data collected from 1986 to 2002 for the Consumer Expenditure Survey conducted by the federal Bureau of Labor Statistics. Blacks and Hispanics spend up to 30% more than whites of comparable income on visible goods like clothing, cars and jewelry, the researchers found. This meant that, compared to white households of similar income, the typical black and Hispanic household spent $2,300 more per year on visible items. To do that, they spent less on almost all other categories except housing, and they saved less.

Visible items are those others can see when one is in public. The researchers found that blacks and Hispanics do not spend more than whites on items, such as home furnishings, that could serve as status symbols but aren't seen by as many people.

Alabama vs. Massachusetts

While Roussanov and his colleagues acknowledge that cultural preferences may play a role in these spending choices, they tested that theory by subdividing blacks, Hispanics and whites by income level and state of residence. This caused the differences in spending patterns to disappear. What really matters, Roussanov, Charles and Hurst found, is not one's race but one's economic situation relative to the "reference group" -- people in the immediate community. "This is not really about race in the end. It is simply about what we observe about you and what peer group you belong to," Roussanov says.

Poor blacks and poor whites both spend more on visible goods if they live in poor communities, because such spending gives them more status relative to others in the community. But poor blacks and poor whites living among wealthier people do not devote extra portions of income to visible expenditures, since they are too far behind to get more status from the extra spending they can afford. Moreover, the very fact of belonging to a particular group provides observers with information about one's likely income (e.g. blacks are on average poorer than whites).

A low-income white person in Alabama, for example, is likely to spend more on visible goods than a low-income white person in Massachusetts. That's because white people are generally poorer in Alabama; in wealthy Massachusetts, spending more on visible goods is a waste of money, since it does not boost one's status.

Blacks and whites appear to have different spending habits only because blacks tend to be concentrated in poor communities more than whites, Roussanov says. Nationally, the poor white is likely to be surrounded by many whites who are not as poor, so he or she cannot afford to use conspicuous consumption to compete for status. But a black person of the same income is more likely to be surrounded by others of similar income, making this competition feasible.

In all races, people of a given income become less and less likely to emphasize conspicuous consumption as they get farther and farther behind their neighbors financially. "The overall predominance of conspicuous consumption between blacks and whites is really not a black-white phenomenon; it is simply an artifact of the environment," Roussanov says. "Blacks are poorer in this country, and so are Hispanics."

The research suggests that Cosby and others are wrong to blame cultural reasons for spending priorities -- or are oversimplifying the matter. But that does not mean these critics are wrong about the consequences. Money spent on conspicuous consumption must be diverted from other uses, and many studies have shown that blacks and Hispanics save less toward goals like college expenses and retirement than whites with the same income.

Roussanov and his colleagues find that blacks and Hispanics spend 16% and 30% less, respectively, on education than whites of similar income. They spend 50% less on health care. Spending on health and education is not as visible to as many people as spending on cars and clothes, so it does not contribute as much to one's status.

Status vs. Fashion

The research indicates that spending habits are heavily influenced by a deep-seated yearning for status rather than transient fashion following. That could make the behavior harder to change, assuming that education, health and savings should come before shoes and jewelry.

Roussanov notes that spending on conspicuous consumption is not entirely counterproductive. In many communities, he says, it may be necessary to present a more affluent image to compete for jobs and to have a social life.

This may explain the chief exception the researchers found in the data: Older people don't spend more on visible goods, even if their incomes are the same as those of younger people who do. Perhaps it's the wisdom of age, or the fact that older people grew up in different times. But it's more likely, says Roussanov, that older people, regardless of their community, don't need status symbols as much because they're not out hunting for jobs and mates.

That reinforces the conclusion that spending for status is a deeply entrenched habit among those who do it. "It seems like health and education should receive more funding by individuals, but we can't simply force that on people and think it will make them better off," Roussanov says. "How do we promote going to an expensive college rather than buying an expensive watch? There's no simple fix to it."

The research, he notes, may have some practical implications for government policy and marketing.

This spring, for example, millions of American households are receiving government checks as part of the economic stimulus package approved earlier in the year. Policymakers' predictions about how people will spend the money may turn out to be far off the mark, given what this research shows about spending incentives among different income groups, Roussanov suggests. "We cannot just assume that the same money is going to be spent the same way by people in different groups."

Marketers advertising cars, clothes and jewelry have long known of the higher demand for flashier products in poorer communities, Roussanov says. But the new insights might be useful, he notes, to companies marketing mutual funds or other financial services products that have yet to catch on in minority communities. The fact that saving and stock market participation is lower among minorities could be potentially linked to their greater spending on cars and other visible items.

A mutual fund investment is not the kind of possession that can be displayed on the street, making sales difficult for a company trying to sell funds to people who prize visible emblems of prosperity but are less tempted by the financial rewards far in the future. Perhaps one (although costly) way to overcome this problem, according to Roussanov, would be to set up branch offices in poorer communities. One could then gain status by being seen visiting a financial advisor. "If you want to make [investing] behavior more prominent," he says, "you have to make the behavior more visible."

Grassoline: Biofuels beyond Corn

Scientists are turning agricultural leftovers, wood and fast-growing grasses into a huge variety of biofuels—even jet fuel. But before these next-generation biofuels go mainstream, they have to compete with oil at $60 a barrel

By George W. Huber and Bruce E. Dale   

In general, this process involves first deconstructing the solid biomass into smaller molecules, then refining these products into fuels. Engineers generally classify deconstruction methods by temperature. The low-temperature method (50 to 200 degrees Celsius) produces sugars that can be fermented into ethanol and other fuels in much the same way that corn or sugar crops are now processed. Deconstruction at higher temperatures (300 to 600 degrees C) produces a biocrude, or bio-oil, that can be refined into gasoline or diesel. Extremely high temperature deconstruction (above 700 degrees C) produces gas that can be converted into liquid fuel.

So far no one knows which approach will convert the maximum amount of the stored energy into liquid biofuels at the lowest costs. Perhaps different pathways will be needed for different cellulosic biomass materials. High-temperature processing might be best for wood, say, whereas low temperatures might work better for grasses.

Hot Fuel
The high-temperature syngas approach is the most technically developed way to generate biofuels. Syngas—a mixture of carbon monoxide and hydrogen—can be made from any carbon-containing material. It is typically transformed into diesel fuel, gasoline or ethanol through a process called Fischer-Tropsch synthesis (FTS), developed by German scientists in the 1920s. During World War II the Third Reich used FTS to create liquid fuel out of Germany’s coal reserves. Most of the major oil companies still have a syngas conversion technology that they may introduce if gasoline becomes prohibitively expensive.

The first step in creating a syngas is called gasification. Biomass is fed into a reactor and heated to temperatures above 700 degrees C. It is then mixed with steam or oxygen to produce a gas containing carbon monoxide, hydrogen gas and tars. The tars must be cleaned out and the gas compressed to 20 to 70 atmospheres of pressure. The compressed syngas then flows over a specially designed catalyst—a solid material that holds the individual reactant molecules and preferentially encourages particular chemical reactions. Syngas conversion catalysts have been developed by the petroleum chemistry primarily for converting natural gas and coal-derived syngas into fuels, but they work just as well for biomass.

Although the technology is well understood, the reactors are expensive. An FTS plant built in Qatar in 2006 to convert natural gas into 34,000 barrels a day of liquid fuels cost $1.6 billion. If a biomass plant were to cost this much, it would have to consume around 5,000 tons of biomass a day, every day, for a period of 15 to 30 years to produce enough fuel to repay the investment. Because significant logistic and economic challenges exist with getting this amount of biomass to a single location, research in syngas technology focuses on ways to reduce the capital costs.

Bio-Oil
Eons of subterranean pressure and heat transformed Cambrian zooplankton and algae into present-day petroleum fields. A similar trick—on a much reduced timescale—could convert cellulosic biomass into a biocrude. In this scenario, a refinery heats up biomass to anywhere from 300 to 600 degrees C in an oxygen-free environment. The heat breaks the biomass down into a charcoal-like solid and the bio-oil, giving off some gas in the process. The bio-oil that is produced by this method is the cheapest liquid biofuel on the market today, perhaps $0.50 per gallon of gasoline energy equivalent (in addition to the cost of the raw biomass).

The process can also be carried out in relatively small factories that are close to where biomass is harvested, thus limiting the expense of biomass transport. Unfortunately, this crude is highly acidic, is insoluble with petroleum-based fuels and contains only half the energy content of gasoline. Although you can burn biocrude directly in a diesel engine, you should attempt it only if you no longer have a need for the engine.

Oil refineries could convert this biocrude into a usable fuel, however, and many companies are studying how they could adapt their existing hardware to the task. Some are already producing a different form of green diesel fuel, suggesting that refineries could handle cellulosic biocrude as well. At the moment, the facilities co-feed vegetable oils and animal fats with petroleum oil directly into their refinery. ConocoPhillips recently demonstrated this approach at a refinery in Borger, Tex., creating more than 12,000 gallons of biodiesel a day out of beef fat shipped from a nearby Tyson Foods slaughterhouse.

Researchers are also figuring out ways to carry out the two-stage process using the chemical engineering equivalent of one-pot cooking—converting the solid biomass to oil and then the oil into fuel inside a single reactor. One of us (Huber) and his colleagues are developing an approach called catalytic fast pyrolysis. The “fast” in the name comes from the initial heating—once biomass enters the reactor, it is cooked to 500 degrees C in a second, which breaks down the large molecules into smaller ones. Like eggs in an egg carton, these small molecules are now the perfect size and shape to fit into the surface of a catalyst.

Once ensconced inside the catalyst’s pores, the molecules go through a series of reactions that change them into gasoline—specifically, the high-value aromatic components of gasoline that increase the octane [see box on page 55]. (High-octane fuels allow engines to run at higher internal pressures, which increases efficiency.) The entire process takes just two to 10 seconds. Already the start-up company Anellotech is attempting to scale up this process from the laboratory to the commercial level. It expects to have a commercial facility in operation by 2014.

Sugar Solution
The route that has attracted most of the public and private investment thus far relies on a more traditional mechanism—unlock the sugars in plants, then ferment these sugars into ethanol or other biofuels. Scientists have studied literally dozens of possible ways to break down the digestion-resistant cellulose and hemicellulose—the fibers that bind cellulose together inside the cells—to their constituent sugars. You can heat the biomass, irradiate it with gamma rays, grind it into a fine slurry, or subject it to high-temperature steam. You can douse it with concentrated acids or bases or bathe it in solvents. You can even genetically engineer microbes that will eat and degrade the cellulose.

Unfortunately, many techniques that work in the lab have no chance of succeeding in commercial practice. To be commercially viable, the pretreatments must generate easily fermentable sugars at high yields and concentrations and be implemented with modest capital costs. They should not use toxic materials or require too much energy input to work. They must also be able to produce grassoline at a price that can compete with gasoline.

The most promising approaches involve subjecting the biomass to extremes of pH and temperature. We are developing a strategy that uses ammonia—a strong base—in one of our laboratories (Dale’s). In this ammonia fiber expansion (AFEX) process, cellulosic biomass is cooked at 100 degrees C with concentrated ammonia under pressure. When the pressure is released, the ammonia evaporates and is recycled. Subsequently, enzymes convert 90 percent or more of the treated cellulose and hemicellulose to sugars. The yield is so high in part because the approach minimizes the sugar degradation that often occurs in acidic or high-temperature environments. The AFEX process is “dry to dry”: biomass starts as a mostly dry solid and is left dry after treatment, undiluted with water. It thus can provide large amounts of highly concentrated, high-proof ethanol.

AFEX also has the potential to be very inexpensive: a recent economic analysis showed that, assuming biomass can be delivered to the plant for around $50 a ton, AFEX pretreatment, combined with an advanced fermentation process called consolidated bioprocessing, can produce cellulosic ethanol for approximately $1 per gallon of equivalent gasoline energy content, probably selling for less than $2 at the pump.

The Cost of Change
Cost, of course, will be the primary determinant of how fast the use of grassoline will grow. Its main competitor is petroleum, and the petroleum industry has been reaping the technological benefits of dedicated research programs for more than a century. Moreover, most petroleum refineries now in use have already paid off their initial capital costs; grassoline refineries will require investments of hundreds of millions of dollars, a cost that will have to be integrated into the price of the fuel it produces through the years.

Grassoline, on the other hand, enjoys several major advantages over fuels from petroleum and other petroleum alternatives such as oil sands and liquefied coal. First, the raw feedstocks are far less expensive than raw crude, which should help keep costs down once the industry gets up and running. Grassoline will be domestically produced, with the national security benefits that confers. And it is far better for the environment than any fossil fuel–based alternative.

In addition, new analytical tools and computer-modeling techniques will let researchers build better, more efficient biorefinery operations at a rate that would have been unattainable to petroleum engineers just a decade ago. We are gaining a deeper understanding of the properties of our raw feedstocks and the processes we can use to convert them into fuel at an ever increasing pace. The U.S. government’s support for research into alternative forms of energy should help this process to accelerate even further. The stimulus bill signed into law by President Barack Obama earlier this year contained $800 million in funding for the Department of Energy’s Biomass Program, which will accelerate advanced biofuels research and development and provide funding for commercial-scale biorefinery projects. In addition, the bill contained $6 billion in loan guarantees for “leading edge biofuel projects” that will commence construction by October 2011.

Indeed, if the U.S. maintains its current commitment to biofuels, the logistical and conversion challenges the industry now faces should be readily overcome. Over the next five to 15 years, biomass conversion technologies will move from the laboratory to the market, and the number of vehicles powered by cellulosic biofuels will grow dramatically. This move toward grassoline can fundamentally change the world. It is a move that is now long overdue.

The Fat of the Matter
There is a new drive to make fuel off the fat of the land. In April, High Plains Bioenergy opened a biorefinery next to a pork-processing plant in Guymon, Okla. The refinery takes pork fat—an abundant, low-value by-product of the industrial butchering process—and converts it, along with vegetable oil, into biodiesel. The plant is expected to turn 30 million pounds of lard into 30 million gallons of biodiesel a year. In 2010 the High Plains facility will be joined by a plant in Geismar, La., that will be run by Dynamic Fuels, a joint venture between Tyson Foods and energy company Syntroleum. That plant will use the fat from Tyson’s beef, chicken and pork operations to create 75 million gallons of biodiesel and jet fuel annually.

Yet the biodiesel industry has been battered recently, with many plants sitting idle for lack of demand. Low oil prices have made petroleum-based diesel fuel less expensive than biodiesel, which in the U.S. is typically made from soy and vegetable oils. A $1 per gallon federal tax credit for biodiesel has helped soften the blow, but that credit is set to expire at the end of the year. Some manufacturers worry that if the credit disappears, so will their business. Tyson had earlier partnered with ConocoPhillips to produce biodiesel at an existing ConocoPhillips refinery in Borger, Tex. But insecurity about the status of the tax break has put the project on hold.

ABOUT THE AUTHOR(S)
George W. Huber is a professor of chemical engineering at the University of Massachusetts Amherst. In 2003 Scientific American cited his work on hydrogen production from biomass feedstocks as one of the top 50 breakthroughs of the year. He is the founder of Anellotech, a biofuel startup, and serves as an occasional consultant for various oil and biofuel companies. Bruce E. Dale is a professor and former chair of the chemical engineering department at Michigan State University and one of the leaders of the Great Lakes Bioenergy Research Center (greatlakesbioenergy.org). He also occasionally serves as a biofuel industry consultant.

http://www.scientificamerican.com/article.cfm?id=the-science-of-economic-bubbles

The Science of Economic Bubbles and Busts

The worst economic crisis since the Great Depression has prompted a reassessment of how financial markets work and how people make decisions about money

Key Concepts

• The worldwide financial meltdown has caused a new examination of why markets sometimes become overheated and then come crashing down.
• The dot-com blowup and the subsequent housing and credit crises highlight how psychological quirks sometimes trump rationality in investment decision making. Understanding these behaviors elucidates the genesis of booms and busts.
• New models of market dynamics try to protect against financial blowups by mirroring more accurately how markets work. Meanwhile more intelligent regulation may gently steer the home buyer or the retirement saver away from bad decisions.

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It has all the makings of a classic B movie scene. A gunman puts a pistol to the victim’s forehead, and the screen fades to black before a loud bang is heard. A forensic specialist who traces the bullet’s trajectory would see it traversing the brain’s prefrontal cortex—a central site for processing decisions. The few survivors of usually fatal injuries to this brain region should not be surprised to find their personalities dramatically altered. In one of the most cited case histories in all of neurology, Phineas Gage, a 19th-century railroad worker, had his prefrontal cortex penetrated by an iron rod; he lived to tell the tale but could no longer make sensible decisions. Cocaine addicts may actually self-inflict similar damage. The resulting dysfunction may cause even abstaining addicts to crave the drug any time, say, the thudding bass of a techno tune reminds them of when they were stoned.

Even people who do not use illicit drugs or get shot in the head have to contend with the
reality that some of the decisions cooked up by the brain’s frontal lobes may lead them astray. A specific site within the prefrontal cortex, the ventromedial prefrontal cortex (VMPFC) is, in fact, among the suspects in the colossal global economic implosion that has recently rocked the globe.

The VMPFC turns out to be a central location for what economists call “money illusion.” The illusion occurs when people ignore obvious information about the distorting effects of inflation on a purchase and, in an irrational leap, decide that the thing is worth much more than it really is. Money illusion may convince prospective buyers that a house is always a great investment because of the misbegotten perception that prices inexorably rise. Robert J. Shiller, a professor of economics at Yale University, contends that the faulty logic of money illusion contributed to the housing bubble: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.”

Economists have fought for decades about whether money illusion and, more generally, the influence of irrationality on economic transactions are themselves illusory. Milton Friedman, the renowned monetary theorist, postulated that consumers and employers remain undeluded and, as rational beings, take inflation into account when making purchases or paying wages. In other words, they are good judges of the real value of a good.

But the ideas of behavioral economists, who study the role of psychology in making economic decisions, are gaining increasing attention today, as scientists of many stripes struggle to understand why the world economy fell so hard and fast. And their ideas are bolstered by the brain scientists who make inside-the-skull snapshots of the VMPFC and other brain areas. Notably, an experiment reported in March in the Proceedings of the National Academy of Sciences USA by researchers at the University of Bonn in Germany and the California Institute of Technology demonstrated that some of the brain’s decision-making circuitry showed signs of money illusion on images from a brain scanner. A part of the VMPFC lit up in subjects who encountered a larger amount of money, even if the relative buying power of that sum had not changed, because prices had increased as well.

The illumination of a spot behind the forehead responsible for a misconception about money marks just one example of the increasing sophistication of a line of research that has already revealed brain centers involved with the more primal investor motivations of fear (the amyg­dala) and greed (the nucleus accumbens, perhaps, not surprisingly, a locus of sexual desire as well). A high-tech fusing of neuroimaging with behavioral psychology and economics has begun to provide clues to how individuals, and, aggregated on a larger scale, whole economies may run off track. Together these disciplines attempt to discover why an economic system, built with nominal safeguards against collapse, can experience near-catastrophic breakdowns. Some of this research is already being adopted as a guide to action by the Obama administration as it tries to stabilize banks and the housing sector.

The Rationality Illusion
The behavioral ideas now garnering increased attention take exception to some central ideas of modern economic theory, including the view that each buyer and seller constitute an exemplar of Homo economicus, a purely rational being motivated by self-interest. “Under all conditions, man in classical economics is an automaton capable of objective reasoning,” writes financial historian Peter Bernstein.

Another central tenet of the rationalist credo is the efficient-market hypothesis, which holds that all past and current information about a good is reflected in its price—the market reaches an equilibrium point between buyers and sellers at just the “right” price. The only thing that can upset this balance between supply and demand is an outside shock, such as unanticipated price setting by an oil cartel. In this way, the dynamics of the financial system remain in balance. Classical theory dictates that the internal dynamics of the market cannot lead to a feedback cycle in which one price increase begets another, creating a bubble and a later reversal of the cycle that fosters a crippling destabilization of the economy.

A strict interpretation of the efficient-market hypothesis would imply that the risks of a bubble bursting would be reflected in existing market prices—the price of homes and of the risky (subprime) mortgages that were packaged into what are now dubbed “toxic securities.” But if that were so and markets were so efficient, how could prices fall so precipitously? Astonishment about the failure of conventional theory was even expressed by former chair of the Federal Reserve Board Alan Greenspan. A persistent cheerleader for the notion of efficient markets, he told a congressional committee in October 2008: “Those of us who looked to the self-interest of lending institutions to protect shareholder’s equity, myself especially, are in a state of shocked disbelief.”

Animal Spirits
The behavioral economists who are trying to pinpoint the psychological factors that lead to bubbles and severe market disequilibrium are the intellectual heirs of psychologists Amos Tversky and Daniel Kahneman, who began studies in the 1970s that challenged the notion of financial actors as rational robots. Kahneman won the Nobel Prize in Economics in 2002 for this work; Tversky would have assuredly won as well if he were still alive. Their pioneering work addressed money illusion and other psychological foibles, such as our tendency to feel sadder about losing, say, $1,000 than feeling happy about gaining that same amount.

A unifying theme of behavioral economics is the often irrational psychological impulses that underlie financial bubbles and the severe downturns that follow. Shiller, a leader in the field, cites “animal spirits”—a phrase originally used by economist John Maynard Keynes—as an explanation. The business cycle, the normal ebbs and peaks of economic activity, depends on a basic sense of trust for both business and consumers to engage one another every day in routine economic dealings. The basis for trust, however, is not always built on rational assessments. Animal spirits—the gut feeling that, yes, this is the time to buy a house or that sleeper stock—drive people to overconfidence and rash decision making during a boom. These feelings can quickly transmute into panic as anxiety rises and the market heads in the other direction. Emotion-driven decision making complements cognitive biases—money illusion’s failure to account for inflation, for instance—that lead to poor investment logic.

The importance of both emotion and cognitive biases in explaining the global crisis can be witnessed throughout the concatenation of events that, over the past 10 years, left the financial system teetering. Animal spirits propelled Internet stocks to indefensible heights during the dot-com boom and drove their values earthward just a few years later. They were present again when reckless lenders took advantage of low-interest rates to proffer adjustable-rate mortgages on risky, subprime borrowers. A phenomenon like money illusion prevailed: the borrowers of these mortgages failed to calculate what would happen if interest rates rose, which is exactly what happened during the middle of the decade, causing massive numbers of foreclosures and defaults. Securitized mortgages, debt from hundreds to thousands of homeowners packaged by banks into securities and then sold to others, lost most of their value. Banks witnessed their lending capital decline. Credit, the lifeblood of capitalism, vanished, bringing on a global crisis.

Rules of Thumb
Behavioral economics and the related subdiscipline of behavioral finance, which pertains more directly to investment, have also begun to illuminate in more detail how psychological quirks about money can help explain the recent crisis. Money illusion is only one example of irrational thought processes examined by economists. Heuristics, or rules of thumb that we need to react quickly in a crisis, are perhaps a legacy that lingers from our Paleolithic ancestors. Measured reasoning was not an option when facing down a wooly mammoth.  When we are not staring down a wild animal, heuristics can sometimes result in cognitive biases.

Behavioral economists have identified a number of biases, some with direct relevance to bubble economics. In confirmation bias, people overweight information that confirms their viewpoint. Witness the massive run-up in housing prices as people assumed that rising home prices would be a sure bet. The herding behavior that resulted caused massive numbers of people to share this belief. Availability bias, which can prompt decisions based on the most recent information, is one reason that some newspaper editors shunned using the word “crash” in the fall of 2008 in an unsuccessful attempt to avoid a flat panic. Hindsight bias, the feeling that something was known all along, can be witnessed postcrash: investors, homeowners and economists acknowledged that the signs of a bubble were obvious, despite having actively contributed to the rise in home prices.

Neuroeconomics, a close relation of behavioral economics, trains a functional magnetic resonance imaging device or another form of brain imaging on the question of whether these idiosyncratic biases are figments of an academician’s imagination or actually operate in the human mind. Imaging has already confirmed money illusion. But investigators are exploring other questions as well; for instance, does talking about money or looking at it or merely thinking about it activate reward and regret centers inside the skull?

In March at the annual meeting of the Cognitive Neuroscience Society in San Francisco, Julie L. Hall, a graduate student of Richard Gonzalez at the University of Michigan at Ann Arbor, presented research showing that our willingness to take risks with money changes in response to even subtle emotional cues, again undercutting the myth of the steely, cold investor. In the experiment, 24 participants—12 men and 12 women—viewed photographs of happy, angry and neutral faces. After exposure to happy faces, the study’s “investors” had more activation in the nucleus accumbens, a reward center, and consistently invested in more risky stocks rather than embracing the relative safety of bonds.

“Happy faces” were a constant presence during the real estate boom earlier in this decade. The smiling visage and happy talk of Carleton H. Sheets, the late-night real estate infomercial pitchman, promised fortunes to those who lacked cash, credit or previous experience in owning or selling real estate. Lately,  Sheets’s pitch now highlights “Real Profit$ in Foreclosures.”

Behavioral economics has gone beyond just trying to provide explanations for why investors behave as they do. It actually supplies a framework for investing and policy making to help people avoid succumbing to emotion-based or ill-conceived investments.

The arrival of the Obama administration marks a growing acceptance of the discipline. A group of leading behavioral scientists provided guidance on ways to motivate voters and campaign contributors during the presidential campaign. Cass Sunstein, a constitutional scholar who wrote the well-regarded book Nudge, which President Barack Obama has reportedly read, was appointed head of the Office of Information and Regulatory Affairs, which reviews federal regulations. Other officials who are either behavioral economists or aficionados of the discipline are now populating the White House.

Sunstein and his Nudge co-author Richard Thaler, the latter one of the founders of behavioral economics, came up with the term “libertarian paternalism” to describe how a government regulation can nudge people away from an inclination toward poor decision making. It relies on a heuristic called anchoring—a suggestion of how to begin thinking about something in the hope that thought carries over into behavior. People, for example, might be prodded into saving more for retirement if they were enrolled automatically in a pension plan from the outset, rather than merely being given an option to sign up. “Employees are enrolled if they do nothing, but they can opt out,” Thaler remarks. “This assures that absentmindedness does not produce poverty when old.” This idea was reflected in the Obama administration’s plans to automatically enroll people in a retirement plan in their workplace.

Decision making can be more complex than simply responding to a gentle push down a given path. In those circumstances, a “choice architecture” is needed to help someone decide among various options. In buying a house, for instance, purchasers need clearer information about money illusion and the like. “When all mortgages were of the 30-year, fixed-rate variety, choosing the best one was simple—just pick the lowest interest rate,” Thaler says. “Now with variable rates, teaser rates, balloon payments, prepayment penalties, and so forth, choosing the best mortgages requires a Ph.D. in finance.” A choice architecture would require that lenders “map” options clearly for borrowers, reducing an imposing stack of paperwork when buying a house into two neat columns, one that lists the various fees, the other that notes interest payments. Captured in a digital format, for instance, these two spreadsheet columns could be uploaded and compared with offerings from other lenders.

Along similar lines, Yale’s Shiller outlines an intricate strategy designed to avoid the excesses of bubble economics by educating against errors in “economic thinking.” Shiller suggests adopting new units of measurement akin to the unidad de fomento (UF) put in place by the Chilean government in 1967 and also embraced by other Latin American governments. The UF is a safeguard against money illusion, allowing a buyer or seller to know whether a price has increased in real terms or is just an inflationary mirage. It represents the price of a market basket of goods and is so commonly used that Chileans often quote prices in these units. “Chile has been the most effectively inflation-indexed country in the world,” Shiller says. “House prices, mortgages, some rentals, alimony payments, and executive incentive options are often expressed in these inflation units.”

Shiller also remains an ardent advocate of new financial technology that could serve as
antibubble weapons. Regulators are now scrutinizing the sophisticated financial instruments that were supposed to protect against default on the mortgage-backed securities that fueled the housing boom. Shiller, however, argues that derivatives (a class of financial instruments that is meant to shield against risk but whose misuse for speculation contributed to the credit crisis) can help guarantee that there are enough buyers and sellers in housing markets. Derivatives are financial contracts “derived” from an underlying asset, such as a stock, a financial index or even a mortgage.

Despite the potential for abuse, Shiller perceives derivatives as prudent “hedges” against dire economic scenarios. In the housing market, homeowners and lenders might use these financial instruments to insure against falling prices, thereby providing sufficient liquidity to keep sales moving.

Can Biology Save Us?
Ultimately, a solution to the current crisis will have to be informed by new ways of thinking about how investors act. One particularly creative approach would correct deficiencies in existing economic theory by melding the old with the new. Andrew Lo, a professor of finance at the Massachusetts Institute of Technology and an official at a hedge fund, has devised a theory that gives equilibrium economics and the efficient-market hypothesis their due while also acknowledging that classic theory does not reflect the way markets work in all circumstances. It attempts a grand synthesis that combines evo­utionary theory with both classical and behavioral economics. Lo’s approach, in other words, builds on the idea that incorporating Darwinian natural selection into simulations of economic behavior can help yield useful insights into how markets operate and provide more accurate predictions than usual of how financial actors—both individuals and institutions—will behave.

Similar ideas have occurred to economists before. Economist Thorstein Veblen proposed that economics should be an evolutionary science as early as 1898; even earlier Thomas Robert Malthus had a profound influence on Darwin himself with his musings on a “struggle for existence.”

Just as natural selection postulates that certain organisms are best able to survive in a particular ecological niche, the adaptive-market hypothesis considers different market players from banks to mutual funds as “species” that are competing for financial success. And it assumes that these players at times use the seat-of-the-pants heuristics described by behavioral economics when investing (“competing”) and that they sometimes adopt irrational strategies, such as taking bigger risks during a losing streak.

“Economists suffer from a deep psychological disorder that I call ‘physics envy,’ ” Lo says. “We wish that 99 percent of economic behavior could be captured by three simple laws of nature. In fact, economists have 99 laws that capture 3 percent of behavior. Economics is a uniquely human endeavor and, as such, should be understood in the broader context of competition, mutation and natural selection—in other words, evolution.”

Having an evolutionary model to consult may let investors adapt as the risk profiles of different investment strategies shift. But the most important benefit of Lo’s simulations may be an ability to detect when the economy is not in a stable equilibrium, a finding that would warn regulators and investors that a bubble is inflating or else about to explode.

An adaptive-market model can incorporate information about how prices in the market are changing—analogous to how people are adapting to a particular ecological niche. It can go on to deduce whether prices on one day are influencing prices on the next, an indication that investors are engaged in “herding,” as described by behavioral economists, a sign that a bubble may be imminent. As a result of this type of modeling, regulations could also “adapt” as markets shift and thus counter the type of “systemic” risks for which conventional risk models leave the markets unprotected. Lo has advocated the establishment of a Capital Markets Safety Board, similar to the institution that investigates airline accidents, to collect data about past and future risks that could threaten the larger financial system, which could serve as a critical foundation for adaptive-market modeling.

As brain science unravels the roots of investors’ underlying behaviors, it may well find new evidence that the conception of Homo economicus is fundamentally flawed. The rational investor should not care whether she has $10 million and then loses $8 million or, alternatively, whether she has nothing and ends up with $2 million. In either case, the end result is the same.

But behavioral economics experiments routinely show that despite similar outcomes, people (and other primates) hate a loss more than they desire a gain, an evolutionary hand-me-down that encourages organisms to preserve food supplies or to weigh a situation carefully before risking encounters with predators.

One group that does not value perceived losses differently than gains are individuals with autism, a disorder characterized by problems with social interaction. When tested, autistics often demonstrate strict logic when balancing gains and losses, but this seeming rationality may itself denote abnormal behavior. “Adhering to logical, rational principles of ideal economic choice may be biologically unnatural,” says Colin F. Camerer, a professor of behavioral economics at Caltech. Better insight into human psychology gleaned by neuroscientists holds the promise of changing forever our fundamental assumptions about the way entire economies function—and our understanding of the motivations of the individual participants therein, who buy homes or stocks and who have trouble judging whether a dollar is worth as much today as it was yesterday.

FRBSF Economic Letter

2009-18; June 5, 2009

Jobless Recovery Redux?

Although the pace of layoffs appears to be subsiding and the overall economy is showing hints of stabilization, most forecasters expect unemployment to continue to increase in coming months and to recede only gradually as recovery takes hold. In this Economic Letter, we evaluate this projection using data on three labor market indicators: worker flows into and out of unemployment; involuntary part-time employment; and temporary layoffs. We pay particular attention to how these indicators compare with data from previous episodes of recession and recovery. Our analysis generally supports projections that labor market weakness will persist, but our findings offer a basis for even greater pessimism about the outlook for the labor market. Specifically, we suggest that the relatively low level of temporary layoffs and high level of involuntary part-time workers make a jobless recovery similar to the one experienced in 1992 a plausible scenario.

Worker flows and unemployment

The U.S. labor market is always in flux as workers leave or find jobs and employers lay off or hire workers. The U.S. Bureau of Labor Statistics (BLS) tracks the results of all this churning, providing estimates of the number of people who are employed and unemployed each month. For the unemployed, the BLS also reports how long they have been searching for work, known as the duration of unemployment. All of these data are released as part of the monthly national employment report.

Researchers have used these monthly counts to estimate the underlying movements of workers into and out of unemployment. Researchers typically focus on two rates: the inflow rate, or the pace at which workers move into unemployment, and the outflow rate, or the pace at which they move out of unemployment (see Shimer 2005). These flows into and out of unemployment provide information about the dynamics underlying the monthly labor market numbers. As such, they can be useful in gauging labor market weakness and strength around turning points in economic activity. Inflow and outflow rates tend to be cyclical, following ups and downs in the economy. During recessions, the inflow rate generally increases as people lose their jobs and become unemployed. At the same time, the outflow rate decreases, as the slowdown in the economy makes it harder for unemployed workers to find jobs. These cyclical inflow and outflow patterns are shown in Figure 1.

Although the cyclicality in labor market flows is evident across all periods, the relationship between the movements of the two rates has varied over time. In the 1970s and 1980s, recessions were characterized by nearly equivalent relative increases in the inflow rate and declines in the outflow rate. This combined deterioration created large recessionary increases in unemployment. However, these sharp recessionary responses were followed by strong post-recession recoveries, in which the inflow and outflow rates returned to nonrecessionary patterns quickly, resulting in steep declines in the unemployment rate.

This behavior changed notably in the 1991 and 2001 recessions. In both episodes, the main factors behind rising unemployment rates were declines in the outflow rate, not increases in the inflow rate, as Figure 1 shows. In other words, lack of hiring rather than high rates of firing was key in boosting the unemployment rate. As the recessions passed and recoveries began, another divergence from history occurred. In contrast to the 1970s and 1980s, outflow rates moved back to their normal levels relatively slowly, creating the jobless recoveries that followed these two recessions. This dramatic change in the cyclical pattern of inflow and outflow rates was pointed out by Hall (2005) and Shimer (2005, 2007), both of whom showed that in the post-1980s economy, outflow rates account for the lion's share of business cycle fluctuations in the unemployment rate.

During the current recession, both the inflow and outflow rates have shifted significantly, with high levels of firing and low levels of hiring, similar to what was observed in the 1970s and 1980s. We are currently at a historically low outflow rate, meaning that the unemployed find it very difficult to get work and average unemployment spells are getting much longer. At the same time, the recent increase in the inflow rate is comparable to what was observed in the 1970s and 1980s. These factors combined are creating especially weak labor market conditions.

The key question going forward is, what type of recovery lies ahead? Will the inflow and outflow rates experience the same snapback as in the 1970s and 1980s? Or will they retrace their prior paths only gradually, leading to subpar net hiring reminiscent of the recoveries from the 1991 and 2001 recessions? To address this question, we examine how different rates of outflow would affect the path of the unemployment rate.

The outlook for unemployment

Before considering how assumptions about the pace of hiring in a recovery might affect unemployment forecasts, it is useful to see how unemployment would evolve if labor market conditions stayed just as they are today, getting no worse nor better. This benchmark calculation is plotted in Figure 2 as the dashed line. It shows that, if inflow and outflow rates were frozen at today's values, the unemployment rate would plateau at around 10% in early 2010. As the nearby solid gray line indicates, this is roughly in line with the Blue Chip consensus forecast. Of course, in the Blue Chip forecast, the unemployment rate comes down over time, since the forecast anticipates improvements in labor market conditions due to an overall economic recovery.

Next we consider the potential for the path of unemployment to diverge from benchmark and Blue Chip consensus forecasts. This exercise considers how the unemployment rate would evolve if the inflow and outflow rates behaved as they did in previous recoveries. We simulate two alternative recovery paths: the one traced in the 1982­­-1983 recession/recovery, which represents a rapid rebound, and the one in the 1991-1992 recession/recovery, which represents a jobless recovery. The simulation requires that we select a starting point, which is the point at which the inflow rate peaks. We choose December 2008 as our starting point.

As the figure shows, in each simulation, the unemployment rate continues to rise even as job losses slow and the inflow rate begins to decline. This pattern reflects the normal lag between the peak in the inflow rate and the trough in the outflow rate, a gap that arises because firms that stop cutting employment typically do not resume hiring for some time. This lag lasted much longer during the jobless recovery of 1991-1992 than during 1982-1983. As a result, extrapolating to the current situation, the unemployment rate peaks much later and at a higher rate under the 1991-1992 simulation than under the 1982-1983 simulation.

The long and gradual return to pre-recession unemployment levels implied by the Blue Chip consensus forecast is consistent with a labor market recovery that is slightly weaker than that experienced in 1983 and slightly stronger than that experienced in 1992. However, should labor market conditions instead proceed along the path taken in the 1992 recovery, the unemployment rate could peak close to 11% in mid-2010 and remain above 9% through the end of 2011. Whether the actual path of unemployment resembles the Blue Chip consensus or one of the simulations depicted in Figure 2 depends importantly on the speed at which employers hire new workers, which in turn depends on the pace of overall economic recovery and special factors affecting the labor market.

Reasons for pessimism

In addition to information on whether or not individuals are employed, the Current Population Survey (CPS), the monthly BLS survey of households, collects detailed data on the hours people work per week and whether this schedule is voluntary or involuntary. For those who are unemployed, the survey asks if they were laid off and if the layoff is temporary or permanent. In economic downturns, the number of temporary layoffs and the number of involuntary part-time workers generally rises. While this pattern also is evident in the current recession, some notable differences shed light on the prospects for recovery of the outflow rate. Indeed, data on temporary layoffs and the number of workers who are involuntarily working part-time suggest that unemployed workers may be searching for work longer than in previous recessions.

The share of workers who have been laid off temporarily, rather than permanently, is at very low levels, and the number of workers who are involuntarily employed part-time is at historical highs. Both of these factors are likely to slow the recovery of the outflow rate over the course of the next several years. The fraction of workers who are on temporary layoffs as a share of total unemployment has recently been low relative to the 1980s, suggesting fewer workers are waiting to be called back to jobs when the economy improves. Consider the difference between the recession of 1981-1982 and the current downturn. Between July 1981 and November 1982, the share of unemployed workers on temporary layoffs increased dramatically from 16.1% to 20.7%. By contrast, between December 2007 and April 2009, the share of unemployed workers on temporary layoffs fell from 12.8% to 11.9%.

Even more dramatic, however, has been the break from past patterns in the number of workers who are involuntarily employed part-time. Numerous reports tell of workers being furloughed for a set number of days in a month or asked to work fewer hours each day. These anecdotes are supported by the monthly data. Indeed, the number of workers employed part-time against their wishes is at historical highs. The fraction of the labor force that reports working part-time for economic reasons has increased from 3.0% in December 2007 to 5.8% in April 2009. This increase has been broad-based, occurring in a wide range of occupations. Moreover, the reduction in hours has not been trivial, with more than half of such workers experiencing reductions of five hours per week or more.

What does all this mean for the course of the labor market? We combine data on involuntary part-time workers with the standard unemployment rate to arrive at an alternative measure of labor underutilization. We plot this measure in Figure 3, which shows that the labor market has considerably more slack than the official unemployment rate indicates. The figure extends this labor underutilization measure using the Blue Chip consensus forecast for the unemployment rate as a benchmark and then adding a share of involuntary part-time workers based on the proportion of workers in that category to the unemployed during the current recession. This projection indicates that the level of labor market slack would be higher by the end of 2009 than experienced at any other time in the post-World War II period, implying a longer and slower recovery path for the unemployment rate. This suggests that, more than in previous recessions, when the economy rebounds, employers will tap into their existing workforces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates.

Mary Daly
Vice President

Bart Hobijn
Research Advisor

Joyce Kwok
Research Associate

References

Hall, Robert. E. 2005. "Job Loss, Job-Finding, and Unemployment in the U.S. Economy over the Past Fifty Years." NBER Macroeconomics Annual, pp. 101-137.

Shimer, Robert J. 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies." American Economic Review 95(1), pp. 25-49.

Shimer, Robert J. 2007. "Reassessing the Ins and Outs of Unemployment." NBER Working Paper 13421.

The Cost Conundrum

What a Texas town can teach us about health care.

by Atul Gawande June 1, 2009

It is spring in McAllen, Texas. The morning sun is warm. The streets are lined with palm trees and pickup trucks. McAllen is in Hidalgo County, which has the lowest household income in the country, but it’s a border town, and a thriving foreign-trade zone has kept the unemployment rate below ten per cent. McAllen calls itself the Square Dance Capital of the World. “Lonesome Dove” was set around here.

McAllen has another distinction, too: it is one of the most expensive health-care markets in the country. Only Miami—which has much higher labor and living costs—spends more per person on health care. In 2006, Medicare spent fifteen thousand dollars per enrollee here, almost twice the national average. The income per capita is twelve thousand dollars. In other words, Medicare spends three thousand dollars more per person here than the average person earns.

The explosive trend in American medical costs seems to have occurred here in an especially intense form. Our country’s health care is by far the most expensive in the world. In Washington, the aim of health-care reform is not just to extend medical coverage to everybody but also to bring costs under control. Spending on doctors, hospitals, drugs, and the like now consumes more than one of every six dollars we earn. The financial burden has damaged the global competitiveness of American businesses and bankrupted millions of families, even those with insurance. It’s also devouring our government. “The greatest threat to America’s fiscal health is not Social Security,” President Barack Obama said in a March speech at the White House. “It’s not the investments that we’ve made to rescue our economy during this crisis. By a wide margin, the biggest threat to our nation’s balance sheet is the skyrocketing cost of health care. It’s not even close.”

The question we’re now frantically grappling with is how this came to be, and what can be done about it. McAllen, Texas, the most expensive town in the most expensive country for health care in the world, seemed a good place to look for some answers.

From the moment I arrived, I asked almost everyone I encountered about McAllen’s health costs—a businessman I met at the five-gate McAllen-Miller International Airport, the desk clerks at the Embassy Suites Hotel, a police-academy cadet at McDonald’s. Most weren’t surprised to hear that McAllen was an outlier. “Just look around,” the cadet said. “People are not healthy here.” McAllen, with its high poverty rate, has an incidence of heavy drinking sixty per cent higher than the national average. And the Tex-Mex diet has contributed to a thirty-eight-per-cent obesity rate.

One day, I went on rounds with Lester Dyke, a weather-beaten, ranch-owning fifty-three-year-old cardiac surgeon who grew up in Austin, did his surgical training with the Army all over the country, and settled into practice in Hidalgo County. He has not lacked for business: in the past twenty years, he has done some eight thousand heart operations, which exhausts me just thinking about it. I walked around with him as he checked in on ten or so of his patients who were recuperating at the three hospitals where he operates. It was easy to see what had landed them under his knife. They were nearly all obese or diabetic or both. Many had a family history of heart disease. Few were taking preventive measures, such as cholesterol-lowering drugs, which, studies indicate, would have obviated surgery for up to half of them.

Yet public-health statistics show that cardiovascular-disease rates in the county are actually lower than average, probably because its smoking rates are quite low. Rates of asthma, H.I.V., infant mortality, cancer, and injury are lower, too. El Paso County, eight hundred miles up the border, has essentially the same demographics. Both counties have a population of roughly seven hundred thousand, similar public-health statistics, and similar percentages of non-English speakers, illegal immigrants, and the unemployed. Yet in 2006 Medicare expenditures (our best approximation of over-all spending patterns) in El Paso were $7,504 per enrollee—half as much as in McAllen. An unhealthy population couldn’t possibly be the reason that McAllen’s health-care costs are so high. (Or the reason that America’s are. We may be more obese than any other industrialized nation, but we have among the lowest rates of smoking and alcoholism, and we are in the middle of the range for cardiovascular disease and diabetes.)

Was the explanation, then, that McAllen was providing unusually good health care? I took a walk through Doctors Hospital at Renaissance, in Edinburg, one of the towns in the McAllen metropolitan area, with Robert Alleyn, a Houston-trained general surgeon who had grown up here and returned home to practice. The hospital campus sprawled across two city blocks, with a series of three- and four-story stucco buildings separated by golfing-green lawns and black asphalt parking lots. He pointed out the sights—the cancer center is over here, the heart center is over there, now we’re coming to the imaging center. We went inside the surgery building. It was sleek and modern, with recessed lighting, classical music piped into the waiting areas, and nurses moving from patient to patient behind rolling black computer pods. We changed into scrubs and Alleyn took me through the sixteen operating rooms to show me the laparoscopy suite, with its flat-screen video monitors, the hybrid operating room with built-in imaging equipment, the surgical robot for minimally invasive robotic surgery.

I was impressed. The place had virtually all the technology that you’d find at Harvard and Stanford and the Mayo Clinic, and, as I walked through that hospital on a dusty road in South Texas, this struck me as a remarkable thing. Rich towns get the new school buildings, fire trucks, and roads, not to mention the better teachers and police officers and civil engineers. Poor towns don’t. But that rule doesn’t hold for health care.

At McAllen Medical Center, I saw an orthopedic surgeon work under an operating microscope to remove a tumor that had wrapped around the spinal cord of a fourteen-year-old. At a home-health agency, I spoke to a nurse who could provide intravenous-drug therapy for patients with congestive heart failure. At McAllen Heart Hospital, I watched Dyke and a team of six do a coronary-artery bypass using technologies that didn’t exist a few years ago. At Renaissance, I talked with a neonatologist who trained at my hospital, in Boston, and brought McAllen new skills and technologies for premature babies. “I’ve had nurses come up to me and say, ‘I never knew these babies could survive,’ ” he said.

And yet there’s no evidence that the treatments and technologies available at McAllen are better than those found elsewhere in the country. The annual reports that hospitals file with Medicare show that those in McAllen and El Paso offer comparable technologies—neonatal intensive-care units, advanced cardiac services, PET scans, and so on. Public statistics show no difference in the supply of doctors. Hidalgo County actually has fewer specialists than the national average.

Nor does the care given in McAllen stand out for its quality. Medicare ranks hospitals on twenty-five metrics of care. On all but two of these, McAllen’s five largest hospitals performed worse, on average, than El Paso’s. McAllen costs Medicare seven thousand dollars more per person each year than does the average city in America. But not, so far as one can tell, because it’s delivering better health care.

One night, I went to dinner with six McAllen doctors. All were what you would call bread-and-butter physicians: busy, full-time, private-practice doctors who work from seven in the morning to seven at night and sometimes later, their waiting rooms teeming and their desks stacked with medical charts to review.

Some were dubious when I told them that McAllen was the country’s most expensive place for health care. I gave them the spending data from Medicare. In 1992, in the McAllen market, the average cost per Medicare enrollee was $4,891, almost exactly the national average. But since then, year after year, McAllen’s health costs have grown faster than any other market in the country, ultimately soaring by more than ten thousand dollars per person.

“Maybe the service is better here,” the cardiologist suggested. People can be seen faster and get their tests more readily, he said.

Others were skeptical. “I don’t think that explains the costs he’s talking about,” the general surgeon said.

“It’s malpractice,” a family physician who had practiced here for thirty-three years said.

“McAllen is legal hell,” the cardiologist agreed. Doctors order unnecessary tests just to protect themselves, he said. Everyone thought the lawyers here were worse than elsewhere.

That explanation puzzled me. Several years ago, Texas passed a tough malpractice law that capped pain-and-suffering awards at two hundred and fifty thousand dollars. Didn’t lawsuits go down?

“Practically to zero,” the cardiologist admitted.

“Come on,” the general surgeon finally said. “We all know these arguments are bullshit. There is overutilization here, pure and simple.” Doctors, he said, were racking up charges with extra tests, services, and procedures.

The surgeon came to McAllen in the mid-nineties, and since then, he said, “the way to practice medicine has changed completely. Before, it was about how to do a good job. Now it is about ‘How much will you benefit?’ ”

Everyone agreed that something fundamental had changed since the days when health-care costs in McAllen were the same as those in El Paso and elsewhere. Yes, they had more technology. “But young doctors don’t think anymore,” the family physician said.

The surgeon gave me an example. General surgeons are often asked to see patients with pain from gallstones. If there aren’t any complications—and there usually aren’t—the pain goes away on its own or with pain medication. With instruction on eating a lower-fat diet, most patients experience no further difficulties. But some have recurrent episodes, and need surgery to remove their gallbladder.

Seeing a patient who has had uncomplicated, first-time gallstone pain requires some judgment. A surgeon has to provide reassurance (people are often scared and want to go straight to surgery), some education about gallstone disease and diet, perhaps a prescription for pain; in a few weeks, the surgeon might follow up. But increasingly, I was told, McAllen surgeons simply operate. The patient wasn’t going to moderate her diet, they tell themselves. The pain was just going to come back. And by operating they happen to make an extra seven hundred dollars.

I gave the doctors around the table a scenario. A forty-year-old woman comes in with chest pain after a fight with her husband. An EKG is normal. The chest pain goes away. She has no family history of heart disease. What did McAllen doctors do fifteen years ago?

Send her home, they said. Maybe get a stress test to confirm that there’s no issue, but even that might be overkill.

And today? Today, the cardiologist said, she would get a stress test, an echocardiogram, a mobile Holter monitor, and maybe even a cardiac catheterization.

“Oh, she’s definitely getting a cath,” the internist said, laughing grimly.

To determine whether overuse of medical care was really the problem in McAllen, I turned to Jonathan Skinner, an economist at Dartmouth’s Institute for Health Policy and Clinical Practice, which has three decades of expertise in examining regional patterns in Medicare payment data. I also turned to two private firms—D2Hawkeye, an independent company, and Ingenix, UnitedHealthcare’s data-analysis company—to analyze commercial insurance data for McAllen. The answer was yes. Compared with patients in El Paso and nationwide, patients in McAllen got more of pretty much everything—more diagnostic testing, more hospital treatment, more surgery, more home care.

The Medicare payment data provided the most detail. Between 2001 and 2005, critically ill Medicare patients received almost fifty per cent more specialist visits in McAllen than in El Paso, and were two-thirds more likely to see ten or more specialists in a six-month period. In 2005 and 2006, patients in McAllen received twenty per cent more abdominal ultrasounds, thirty per cent more bone-density studies, sixty per cent more stress tests with echocardiography, two hundred per cent more nerve-conduction studies to diagnose carpal-tunnel syndrome, and five hundred and fifty per cent more urine-flow studies to diagnose prostate troubles. They received one-fifth to two-thirds more gallbladder operations, knee replacements, breast biopsies, and bladder scopes. They also received two to three times as many pacemakers, implantable defibrillators, cardiac-bypass operations, carotid endarterectomies, and coronary-artery stents. And Medicare paid for five times as many home-nurse visits. The primary cause of McAllen’s extreme costs was, very simply, the across-the-board overuse of medicine.

This is a disturbing and perhaps surprising diagnosis. Americans like to believe that, with most things, more is better. But research suggests that where medicine is concerned it may actually be worse. For example, Rochester, Minnesota, where the Mayo Clinic dominates the scene, has fantastically high levels of technological capability and quality, but its Medicare spending is in the lowest fifteen per cent of the country—$6,688 per enrollee in 2006, which is eight thousand dollars less than the figure for McAllen. Two economists working at Dartmouth, Katherine Baicker and Amitabh Chandra, found that the more money Medicare spent per person in a given state the lower that state’s quality ranking tended to be. In fact, the four states with the highest levels of spending—Louisiana, Texas, California, and Florida—were near the bottom of the national rankings on the quality of patient care.

In a 2003 study, another Dartmouth team, led by the internist Elliott Fisher, examined the treatment received by a million elderly Americans diagnosed with colon or rectal cancer, a hip fracture, or a heart attack. They found that patients in higher-spending regions received sixty per cent more care than elsewhere. They got more frequent tests and procedures, more visits with specialists, and more frequent admission to hospitals. Yet they did no better than other patients, whether this was measured in terms of survival, their ability to function, or satisfaction with the care they received. If anything, they seemed to do worse.

That’s because nothing in medicine is without risks. Complications can arise from hospital stays, medications, procedures, and tests, and when these things are of marginal value the harm can be greater than the benefits. In recent years, we doctors have markedly increased the number of operations we do, for instance. In 2006, doctors performed at least sixty million surgical procedures, one for every five Americans. No other country does anything like as many operations on its citizens. Are we better off for it? No one knows for sure, but it seems highly unlikely. After all, some hundred thousand people die each year from complications of surgery—far more than die in car crashes.

To make matters worse, Fisher found that patients in high-cost areas were actually less likely to receive low-cost preventive services, such as flu and pneumonia vaccines, faced longer waits at doctor and emergency-room visits, and were less likely to have a primary-care physician. They got more of the stuff that cost more, but not more of what they needed.

In an odd way, this news is reassuring. Universal coverage won’t be feasible unless we can control costs. Policymakers have worried that doing so would require rationing, which the public would never go along with. So the idea that there’s plenty of fat in the system is proving deeply attractive. “Nearly thirty per cent of Medicare’s costs could be saved without negatively affecting health outcomes if spending in high- and medium-cost areas could be reduced to the level in low-cost areas,” Peter Orszag, the President’s budget director, has stated.

Most Americans would be delighted to have the quality of care found in places like Rochester, Minnesota, or Seattle, Washington, or Durham, North Carolina—all of which have world-class hospitals and costs that fall below the national average. If we brought the cost curve in the expensive places down to their level, Medicare’s problems (indeed, almost all the federal government’s budget problems for the next fifty years) would be solved. The difficulty is how to go about it. Physicians in places like McAllen behave differently from others. The $2.4-trillion question is why. Unless we figure it out, health reform will fail.

I had what I considered to be a reasonable plan for finding out what was going on in McAllen. I would call on the heads of its hospitals, in their swanky, decorator-designed, churrigueresco offices, and I’d ask them.

The first hospital I visited, McAllen Heart Hospital, is owned by Universal Health Services, a for-profit hospital chain with headquarters in King of Prussia, Pennsylvania, and revenues of five billion dollars last year. I went to see the hospital’s chief operating officer, Gilda Romero. Truth be told, her office seemed less churrigueresco than Office Depot. She had straight brown hair, sympathetic eyes, and looked more like a young school teacher than like a corporate officer with nineteen years of experience. And when I inquired, “What is going on in this place?” she looked surprised.

Is McAllen really that expensive? she asked.

I described the data, including the numbers indicating that heart operations and catheter procedures and pacemakers were being performed in McAllen at double the usual rate.

“That is interesting,” she said, by which she did not mean, “Uh-oh, you’ve caught us” but, rather, “That is actually interesting.” The problem of McAllen’s outlandish costs was new to her. She puzzled over the numbers. She was certain that her doctors performed surgery only when it was necessary. It had to be one of the other hospitals. And she had one in mind—Doctors Hospital at Renaissance, the hospital in Edinburg that I had toured.

She wasn’t the only person to mention Renaissance. It is the newest hospital in the area. It is physician-owned. And it has a reputation (which it disclaims) for aggressively recruiting high-volume physicians to become investors and send patients there. Physicians who do so receive not only their fee for whatever service they provide but also a percentage of the hospital’s profits from the tests, surgery, or other care patients are given. (In 2007, its profits totalled thirty-four million dollars.) Romero and others argued that this gives physicians an unholy temptation to overorder.

Such an arrangement can make physician investors rich. But it can’t be the whole explanation. The hospital gets barely a sixth of the patients in the region; its margins are no bigger than the other hospitals’—whether for profit or not for profit—and it didn’t have much of a presence until 2004 at the earliest, a full decade after the cost explosion in McAllen began.

“Those are good points,” Romero said. She couldn’t explain what was going on.

The following afternoon, I visited the top managers of Doctors Hospital at Renaissance. We sat in their boardroom around one end of a yacht-length table. The chairman of the board offered me a soda. The chief of staff smiled at me. The chief financial officer shook my hand as if I were an old friend. The C.E.O., however, was having a hard time pretending that he was happy to see me. Lawrence Gelman was a fifty-seven-year-old anesthesiologist with a Bill Clinton shock of white hair and a weekly local radio show tag-lined “Opinions from an Unrelenting Conservative Spirit.” He had helped found the hospital. He barely greeted me, and while the others were trying for a how-can-I-help-you-today attitude, his body language was more let’s-get-this-over-with.

So I asked him why McAllen’s health-care costs were so high. What he gave me was a disquisition on the theory and history of American health-care financing going back to Lyndon Johnson and the creation of Medicare, the upshot of which was: (1) Government is the problem in health care. “The people in charge of the purse strings don’t know what they’re doing.” (2) If anything, government insurance programs like Medicare don’t pay enough. “I, as an anesthesiologist, know that they pay me ten per cent of what a private insurer pays.” (3) Government programs are full of waste. “Every person in this room could easily go through the expenditures of Medicare and Medicaid and see all kinds of waste.” (4) But not in McAllen. The clinicians here, at least at Doctors Hospital at Renaissance, “are providing necessary, essential health care,” Gelman said. “We don’t invent patients.”

Then why do hospitals in McAllen order so much more surgery and scans and tests than hospitals in El Paso and elsewhere?

In the end, the only explanation he and his colleagues could offer was this: The other doctors and hospitals in McAllen may be overspending, but, to the extent that his hospital provides costlier treatment than other places in the country, it is making people better in ways that data on quality and outcomes do not measure.

“Do we provide better health care than El Paso?” Gelman asked. “I would bet you two to one that we do.”

It was a depressing conversation—not because I thought the executives were being evasive but because they weren’t being evasive. The data on McAllen’s costs were clearly new to them. They were defending McAllen reflexively. But they really didn’t know the big picture of what was happening.

And, I realized, few people in their position do. Local executives for hospitals and clinics and home-health agencies understand their growth rate and their market share; they know whether they are losing money or making money. They know that if their doctors bring in enough business—surgery, imaging, home-nursing referrals—they make money; and if they get the doctors to bring in more, they make more. But they have only the vaguest notion of whether the doctors are making their communities as healthy as they can, or whether they are more or less efficient than their counterparts elsewhere. A doctor sees a patient in clinic, and has her check into a McAllen hospital for a CT scan, an ultrasound, three rounds of blood tests, another ultrasound, and then surgery to have her gallbladder removed. How is Lawrence Gelman or Gilda Romero to know whether all that is essential, let alone the best possible treatment for the patient? It isn’t what they are responsible or accountable for.

Health-care costs ultimately arise from the accumulation of individual decisions doctors make about which services and treatments to write an order for. The most expensive piece of medical equipment, as the saying goes, is a doctor’s pen. And, as a rule, hospital executives don’t own the pen caps. Doctors do.

If doctors wield the pen, why do they do it so differently from one place to another? Brenda Sirovich, another Dartmouth researcher, published a study last year that provided an important clue. She and her team surveyed some eight hundred primary-care physicians from high-cost cities (such as Las Vegas and New York), low-cost cities (such as Sacramento and Boise), and others in between. The researchers asked the physicians specifically how they would handle a variety of patient cases. It turned out that differences in decision-making emerged in only some kinds of cases. In situations in which the right thing to do was well established—for example, whether to recommend a mammogram for a fifty-year-old woman (the answer is yes)—physicians in high- and low-cost cities made the same decisions. But, in cases in which the science was unclear, some physicians pursued the maximum possible amount of testing and procedures; some pursued the minimum. And which kind of doctor they were depended on where they came from.

Sirovich asked doctors how they would treat a seventy-five-year-old woman with typical heartburn symptoms and “adequate health insurance to cover tests and medications.” Physicians in high- and low-cost cities were equally likely to prescribe antacid therapy and to check for H. pylori, an ulcer-causing bacterium—steps strongly recommended by national guidelines. But when it came to measures of less certain value—and higher cost—the differences were considerable. More than seventy per cent of physicians in high-cost cities referred the patient to a gastroenterologist, ordered an upper endoscopy, or both, while half as many in low-cost cities did. Physicians from high-cost cities typically recommended that patients with well-controlled hypertension see them in the office every one to three months, while those from low-cost cities recommended visits twice yearly. In case after uncertain case, more was not necessarily better. But physicians from the most expensive cities did the most expensive things.

Why? Some of it could reflect differences in training. I remember when my wife brought our infant son Walker to visit his grandparents in Virginia, and he took a terrifying fall down a set of stairs. They drove him to the local community hospital in Alexandria. A CT scan showed that he had a tiny subdural hematoma—a small area of bleeding in the brain. During ten hours of observation, though, he was fine—eating, drinking, completely alert. I was a surgery resident then and had seen many cases like his. We observed each child in intensive care for at least twenty-four hours and got a repeat CT scan. That was how I’d been trained. But the doctor in Alexandria was going to send Walker home. That was how he’d been trained. Suppose things change for the worse? I asked him. It’s extremely unlikely, he said, and if anything changed Walker could always be brought back. I bullied the doctor into admitting him anyway. The next day, the scan and the patient were fine. And, looking in the textbooks, I learned that the doctor was right. Walker could have been managed safely either way.

There was no sign, however, that McAllen’s doctors as a group were trained any differently from El Paso’s. One morning, I met with a hospital administrator who had extensive experience managing for-profit hospitals along the border. He offered a different possible explanation: the culture of money.

“In El Paso, if you took a random doctor and looked at his tax returns eighty-five per cent of his income would come from the usual practice of medicine,” he said. But in McAllen, the administrator thought, that percentage would be a lot less.

He knew of doctors who owned strip malls, orange groves, apartment complexes—or imaging centers, surgery centers, or another part of the hospital they directed patients to. They had “entrepreneurial spirit,” he said. They were innovative and aggressive in finding ways to increase revenues from patient care. “There’s no lack of work ethic,” he said. But he had often seen financial considerations drive the decisions doctors made for patients—the tests they ordered, the doctors and hospitals they recommended—and it bothered him. Several doctors who were unhappy about the direction medicine had taken in McAllen told me the same thing. “It’s a machine, my friend,” one surgeon explained.

No one teaches you how to think about money in medical school or residency. Yet, from the moment you start practicing, you must think about it. You must consider what is covered for a patient and what is not. You must pay attention to insurance rejections and government-reimbursement rules. You must think about having enough money for the secretary and the nurse and the rent and the malpractice insurance.

Beyond the basics, however, many physicians are remarkably oblivious to the financial implications of their decisions. They see their patients. They make their recommendations. They send out the bills. And, as long as the numbers come out all right at the end of each month, they put the money out of their minds.

Others think of the money as a means of improving what they do. They think about how to use the insurance money to maybe install electronic health records with colleagues, or provide easier phone and e-mail access, or offer expanded hours. They hire an extra nurse to monitor diabetic patients more closely, and to make sure that patients don’t miss their mammograms and pap smears and colonoscopies.

Then there are the physicians who see their practice primarily as a revenue stream. They instruct their secretary to have patients who call with follow-up questions schedule an appointment, because insurers don’t pay for phone calls, only office visits. They consider providing Botox injections for cash. They take a Doppler ultrasound course, buy a machine, and start doing their patients’ scans themselves, so that the insurance payments go to them rather than to the hospital. They figure out ways to increase their high-margin work and decrease their low-margin work. This is a business, after all.

In every community, you’ll find a mixture of these views among physicians, but one or another tends to predominate. McAllen seems simply to be the community at one extreme.

In a few cases, the hospital executive told me, he’d seen the behavior cross over into what seemed like outright fraud. “I’ve had doctors here come up to me and say, ‘You want me to admit patients to your hospital, you’re going to have to pay me.’ ”

“How much?” I asked.

“The amounts—all of them were over a hundred thousand dollars per year,” he said. The doctors were specific. The most he was asked for was five hundred thousand dollars per year.

He didn’t pay any of them, he said: “I mean, I gotta sleep at night.” And he emphasized that these were just a handful of doctors. But he had never been asked for a kickback before coming to McAllen.

Woody Powell is a Stanford sociologist who studies the economic culture of cities. Recently, he and his research team studied why certain regions—Boston, San Francisco, San Diego—became leaders in biotechnology while others with a similar concentration of scientific and corporate talent—Los Angeles, Philadelphia, New York—did not. The answer they found was what Powell describes as the anchor-tenant theory of economic development. Just as an anchor store will define the character of a mall, anchor tenants in biotechnology, whether it’s a company like Genentech, in South San Francisco, or a university like M.I.T., in Cambridge, define the character of an economic community. They set the norms. The anchor tenants that set norms encouraging the free flow of ideas and collaboration, even with competitors, produced enduringly successful communities, while those that mainly sought to dominate did not.

Powell suspects that anchor tenants play a similarly powerful community role in other areas of economics, too, and health care may be no exception. I spoke to a marketing rep for a McAllen home-health agency who told me of a process uncannily similar to what Powell found in biotech. Her job is to persuade doctors to use her agency rather than others. The competition is fierce. I opened the phone book and found seventeen pages of listings for home-health agencies—two hundred and sixty in all. A patient typically brings in between twelve hundred and fifteen hundred dollars, and double that amount for specialized care. She described how, a decade or so ago, a few early agencies began rewarding doctors who ordered home visits with more than trinkets: they provided tickets to professional sporting events, jewelry, and other gifts. That set the tone. Other agencies jumped in. Some began paying doctors a supplemental salary, as “medical directors,” for steering business in their direction. Doctors came to expect a share of the revenue stream.

Agencies that want to compete on quality struggle to remain in business, the rep said. Doctors have asked her for a medical-director salary of four or five thousand dollars a month in return for sending her business. One asked a colleague of hers for private-school tuition for his child; another wanted sex.

“I explained the rules and regulations and the anti-kickback law, and told them no,” she said of her dealings with such doctors. “Does it hurt my business?” She paused. “I’m O.K. working only with ethical physicians,” she finally said.

About fifteen years ago, it seems, something began to change in McAllen. A few leaders of local institutions took profit growth to be a legitimate ethic in the practice of medicine. Not all the doctors accepted this. But they failed to discourage those who did. So here, along the banks of the Rio Grande, in the Square Dance Capital of the World, a medical community came to treat patients the way subprime-mortgage lenders treated home buyers: as profit centers.

The real puzzle of American health care, I realized on the airplane home, is not why McAllen is different from El Paso. It’s why El Paso isn’t like McAllen. Every incentive in the system is an invitation to go the way McAllen has gone. Yet, across the country, large numbers of communities have managed to control their health costs rather than ratchet them up.

I talked to Denis Cortese, the C.E.O. of the Mayo Clinic, which is among the highest-quality, lowest-cost health-care systems in the country. A couple of years ago, I spent several days there as a visiting surgeon. Among the things that stand out from that visit was how much time the doctors spent with patients. There was no churn—no shuttling patients in and out of rooms while the doctor bounces from one to the other. I accompanied a colleague while he saw patients. Most of the patients, like those in my clinic, required about twenty minutes. But one patient had colon cancer and a number of other complex issues, including heart disease. The physician spent an hour with her, sorting things out. He phoned a cardiologist with a question.

“I’ll be there,” the cardiologist said.

Fifteen minutes later, he was. They mulled over everything together. The cardiologist adjusted a medication, and said that no further testing was needed. He cleared the patient for surgery, and the operating room gave her a slot the next day.

The whole interaction was astonishing to me. Just having the cardiologist pop down to see the patient with the surgeon would be unimaginable at my hospital. The time required wouldn’t pay. The time required just to organize the system wouldn’t pay.

The core tenet of the Mayo Clinic is “The needs of the patient come first”—not the convenience of the doctors, not their revenues. The doctors and nurses, and even the janitors, sat in meetings almost weekly, working on ideas to make the service and the care better, not to get more money out of patients. I asked Cortese how the Mayo Clinic made this possible.

“It’s not easy,” he said. But decades ago Mayo recognized that the first thing it needed to do was eliminate the financial barriers. It pooled all the money the doctors and the hospital system received and began paying everyone a salary, so that the doctors’ goal in patient care couldn’t be increasing their income. Mayo promoted leaders who focussed first on what was best for patients, and then on how to make this financially possible.

No one there actually intends to do fewer expensive scans and procedures than is done elsewhere in the country. The aim is to raise quality and to help doctors and other staff members work as a team. But, almost by happenstance, the result has been lower costs.

“When doctors put their heads together in a room, when they share expertise, you get more thinking and less testing,” Cortese told me.

Skeptics saw the Mayo model as a local phenomenon that wouldn’t carry beyond the hay fields of northern Minnesota. But in 1986 the Mayo Clinic opened a campus in Florida, one of our most expensive states for health care, and, in 1987, another one in Arizona. It was difficult to recruit staff members who would accept a salary and the Mayo’s collaborative way of practicing. Leaders were working against the dominant medical culture and incentives. The expansion sites took at least a decade to get properly established. But eventually they achieved the same high-quality, low-cost results as Rochester. Indeed, Cortese says that the Florida site has become, in some respects, the most efficient one in the system.

The Mayo Clinic is not an aberration. One of the lowest-cost markets in the country is Grand Junction, Colorado, a community of a hundred and twenty thousand that nonetheless has achieved some of Medicare’s highest quality-of-care scores. Michael Pramenko is a family physician and a local medical leader there. Unlike doctors at the Mayo Clinic, he told me, those in Grand Junction get piecework fees from insurers. But years ago the doctors agreed among themselves to a system that paid them a similar fee whether they saw Medicare, Medicaid, or private-insurance patients, so that there would be little incentive to cherry-pick patients. They also agreed, at the behest of the main health plan in town, an H.M.O., to meet regularly on small peer-review committees to go over their patient charts together. They focussed on rooting out problems like poor prevention practices, unnecessary back operations, and unusual hospital-complication rates. Problems went down. Quality went up. Then, in 2004, the doctors’ group and the local H.M.O. jointly created a regional information network—a community-wide electronic-record system that shared office notes, test results, and hospital data for patients across the area. Again, problems went down. Quality went up. And costs ended up lower than just about anywhere else in the United States.

Grand Junction’s medical community was not following anyone else’s recipe. But, like Mayo, it created what Elliott Fisher, of Dartmouth, calls an accountable-care organization. The leading doctors and the hospital system adopted measures to blunt harmful financial incentives, and they took collective responsibility for improving the sum total of patient care.

This approach has been adopted in other places, too: the Geisinger Health System, in Danville, Pennsylvania; the Marshfield Clinic, in Marshfield, Wisconsin; Intermountain Healthcare, in Salt Lake City; Kaiser Permanente, in Northern California. All of them function on similar principles. All are not-for-profit institutions. And all have produced enviably higher quality and lower costs than the average American town enjoys.

When you look across the spectrum from Grand Junction to McAllen—and the almost threefold difference in the costs of care—you come to realize that we are witnessing a battle for the soul of American medicine. Somewhere in the United States at this moment, a patient with chest pain, or a tumor, or a cough is seeing a doctor. And the damning question we have to ask is whether the doctor is set up to meet the needs of the patient, first and foremost, or to maximize revenue.

There is no insurance system that will make the two aims match perfectly. But having a system that does so much to misalign them has proved disastrous. As economists have often pointed out, we pay doctors for quantity, not quality. As they point out less often, we also pay them as individuals, rather than as members of a team working together for their patients. Both practices have made for serious problems.

Providing health care is like building a house. The task requires experts, expensive equipment and materials, and a huge amount of coördination. Imagine that, instead of paying a contractor to pull a team together and keep them on track, you paid an electrician for every outlet he recommends, a plumber for every faucet, and a carpenter for every cabinet. Would you be surprised if you got a house with a thousand outlets, faucets, and cabinets, at three times the cost you expected, and the whole thing fell apart a couple of years later? Getting the country’s best electrician on the job (he trained at Harvard, somebody tells you) isn’t going to solve this problem. Nor will changing the person who writes him the check.

This last point is vital. Activists and policymakers spend an inordinate amount of time arguing about whether the solution to high medical costs is to have government or private insurance companies write the checks. Here’s how this whole debate goes. Advocates of a public option say government financing would save the most money by having leaner administrative costs and forcing doctors and hospitals to take lower payments than they get from private insurance. Opponents say doctors would skimp, quit, or game the system, and make us wait in line for our care; they maintain that private insurers are better at policing doctors. No, the skeptics say: all insurance companies do is reject applicants who need health care and stall on paying their bills. Then we have the economists who say that the people who should pay the doctors are the ones who use them. Have consumers pay with their own dollars, make sure that they have some “skin in the game,” and then they’ll get the care they deserve. These arguments miss the main issue. When it comes to making care better and cheaper, changing who pays the doctor will make no more difference than changing who pays the electrician. The lesson of the high-quality, low-cost communities is that someone has to be accountable for the totality of care. Otherwise, you get a system that has no brakes. You get McAllen.

One afternoon in McAllen, I rode down McColl Road with Lester Dyke, the cardiac surgeon, and we passed a series of office plazas that seemed to be nothing but home-health agencies, imaging centers, and medical-equipment stores.

“Medicine has become a pig trough here,” he muttered.

Dyke is among the few vocal critics of what’s happened in McAllen. “We took a wrong turn when doctors stopped being doctors and became businessmen,” he said.

We began talking about the various proposals being touted in Washington to fix the cost problem. I asked him whether expanding public-insurance programs like Medicare and shrinking the role of insurance companies would do the trick in McAllen.

“I don’t have a problem with it,” he said. “But it won’t make a difference.” In McAllen, government payers already predominate—not many people have jobs with private insurance.

How about doing the opposite and increasing the role of big insurance companies?

“What good would that do?” Dyke asked.

The third class of health-cost proposals, I explained, would push people to use medical savings accounts and hold high-deductible insurance policies: “They’d have more of their own money on the line, and that’d drive them to bargain with you and other surgeons, right?”

He gave me a quizzical look. We tried to imagine the scenario. A cardiologist tells an elderly woman that she needs bypass surgery and has Dr. Dyke see her. They discuss the blockages in her heart, the operation, the risks. And now they’re supposed to haggle over the price as if he were selling a rug in a souk? “I’ll do three vessels for thirty thousand, but if you take four I’ll throw in an extra night in the I.C.U.”—that sort of thing? Dyke shook his head. “Who comes up with this stuff?” he asked. “Any plan that relies on the sheep to negotiate with the wolves is doomed to failure.”

Instead, McAllen and other cities like it have to be weaned away from their untenably fragmented, quantity-driven systems of health care, step by step. And that will mean rewarding doctors and hospitals if they band together to form Grand Junction-like accountable-care organizations, in which doctors collaborate to increase prevention and the quality of care, while discouraging overtreatment, undertreatment, and sheer profiteering. Under one approach, insurers—whether public or private—would allow clinicians who formed such organizations and met quality goals to keep half the savings they generate. Government could also shift regulatory burdens, and even malpractice liability, from the doctors to the organization. Other, sterner, approaches would penalize those who don’t form these organizations.

This will by necessity be an experiment. We will need to do in-depth research on what makes the best systems successful—the peer-review committees? recruiting more primary-care doctors and nurses? putting doctors on salary?—and disseminate what we learn. Congress has provided vital funding for research that compares the effectiveness of different treatments, and this should help reduce uncertainty about which treatments are best. But we also need to fund research that compares the effectiveness of different systems of care—to reduce our uncertainty about which systems work best for communities. These are empirical, not ideological, questions. And we would do well to form a national institute for health-care delivery, bringing together clinicians, hospitals, insurers, employers, and citizens to assess, regularly, the quality and the cost of our care, review the strategies that produce good results, and make clear recommendations for local systems.

Dramatic improvements and savings will take at least a decade. But a choice must be made. Whom do we want in charge of managing the full complexity of medical care? We can turn to insurers (whether public or private), which have proved repeatedly that they can’t do it. Or we can turn to the local medical communities, which have proved that they can. But we have to choose someone—because, in much of the country, no one is in charge. And the result is the most wasteful and the least sustainable health-care system in the world.

Something even more worrisome is going on as well. In the war over the culture of medicine—the war over whether our country’s anchor model will be Mayo or McAllen—the Mayo model is losing. In the sharpest economic downturn that our health system has faced in half a century, many people in medicine don’t see why they should do the hard work of organizing themselves in ways that reduce waste and improve quality if it means sacrificing revenue.

In El Paso, the for-profit health-care executive told me, a few leading physicians recently followed McAllen’s lead and opened their own centers for surgery and imaging. When I was in Tulsa a few months ago, a fellow-surgeon explained how he had made up for lost revenue by shifting his operations for well-insured patients to a specialty hospital that he partially owned while keeping his poor and uninsured patie