The Great Reversal

by Thomas Philippon

  FIGURE A.2  Prices and wages in 2015. (Left): log (PPP) versus log (nominal wage). (Right): Variables are scaled by the FX exchange rate, so this graph plots log (RER) versus log (real wage).

  Let us start by comparing prices and wages across various countries.

  The first panel of Figure A.2 shows that, as expected, nominal prices and wages are proportional across countries: the slope of the lines in the left panel is one. In the second panel, we have the Balassa-Samuelson effect: real exchange rates are higher in countries where real wages are higher. On one hand, clearly, wages explain many of the differences in prices, as expected from basic pricing theory.

  On the other hand, the data also show a great deal of variation in real exchange rates among countries with similar per-capita income. This is consistent with the Ferrari example given in Chapter 7, in which differences in markups explain differences in prices. It is worth noting that many issues arise when we use price indexes to compare costs of living across countries, as discussed in Deaton and Heston (2010). But these issues are most severe when we compare countries at different levels of income and development, or countries in very different climates, because many goods are consumed only in some places and not in others. For instance, the typical basket of food includes rice in Asia but not in Africa. That makes it hard to define a common basket and to compute the relative price index and apply the PPP approach. The relative importance of heating costs and air-conditioning costs are going to be very different for people living in Reykjavik, Iceland, and in Washington, DC. In this book, however, we focus on the comparison between the US and Europe, and we can assume that preferences and available goods are relatively similar.

  More broadly, economists have shown that pricing to market is important. For instance, George Alessandria and Joseph P. Kaboski (2011) find that “deviations from the law of one price in tradable goods are an important source of violations of absolute PPP across countries …: at the U.S. dock, U.S. exporters ship the same good to low-income countries at lower prices. This pricing-to-market is about twice as important as any local non-traded inputs, such as distribution costs, in explaining the differences in tradable prices across countries.”

  D. QUALITY ADJUSTMENTS IN FINANCIAL SERVICES

  Changes in the characteristics of the borrowers require quality adjustments to the raw measure of intermediated assets. For instance, corporate finance involves issuing commercial paper for blue chip companies as well as raising equity for high-technology startups. The monitoring requirements per dollar intermediated are clearly different in these two activities. Similarly, with household finance, it is more expensive to lend to poor households than to wealthy ones, and relatively poor households have gained access to credit in recent years. Using the Survey of Consumer Finances, Kevin B. Moore and Michael G. Palumbo (2010) document that between 1989 and 2007 the fraction of households with positive debt balances increased from 72 percent to 77 percent. This increase is concentrated at the bottom of the income distribution. For households in the 0–40 percentiles of income, the fraction with some debt outstanding goes from 53 percent to 61 percent between 1989 and 2007. Measurement problems arise when the mix of high- and low-quality borrowers changes over time.

  FIGURE A.3  Unit cost and quality adjustment. The quality-adjusted measure takes into account changes in firms’ and households’ characteristics. Data range is 1886–2015. Source: Philippon (2015)

  I therefore perform a quality adjustment to the intermediated assets series, following Philippon (2015). Figure A.3 shows the quality-adjusted unit cost series. It is lower than the unadjusted series by construction, since quality-adjusted assets are (weakly) larger than raw intermediated assets. The gap between the two series grows when there is entry of new firms and when there is credit expansion at the extensive margin (that is, new borrowers). Even with the adjusted series, however, we see no significant decrease in the unit cost of intermediation over time, at least until very recently.

  So, quality adjustments do not explain why finance is still expensive. Guillaume Bazot (2013) finds similar unit costs in other major countries (Germany, UK, France, Japan).

  GLOSSARY

  abuse of dominance: The use of market power by a dominant firm in a way that harms competition, eliminates an existing competitor, or deters entry by new competitors. It is a complex and controversial idea, and its definition differs across jurisdictions. US regulators prefer to talk about monopolization.

  adverse selection: A situation in which some market participants take advantage of private information that other participants do not have. The information can be about the true quality of a good (such as used cars), the true risk of an activity, or the true value of an asset. For instance, informed traders will try to sell their shares when they learn before anyone else that a company is in trouble. Markets can collapse when adverse selection is strong because everyone mistrusts the trading motives of everyone else.

  anti-steering: A contractual arrangement that prevents firms from directing their clients toward some products. Credit card companies prohibit merchants from steering consumers toward cards with lower transaction fees. Hospitals prohibit insurers from steering patients toward cheaper health-care providers. In the mortgage market, on the other hand, anti-steering refers to a regulation that prevents lenders from steering borrowers into high-cost loans.

  antitrust laws: The federal and state laws that promote competition and prevent monopolization. In the late nineteenth century, large companies organized as “trusts” to stifle competition. Antitrust deals mainly with mergers, cartels (price-fixing), and restrictive agreements (such as tie-ins or exclusive contracts). The three core antitrust laws in the US are the Sherman Act (1890), the Federal Trade Commission Act (1914), and the Clayton Act (1914). They are usually called competition laws or anti-monopoly laws outside of the US.

  Balassa-Samuelson effect: The tendency for high productivity in tradable goods to raise wages in other sectors, leading to higher prices in the service sector in richer countries. It explains why, for example, haircuts cost more in Norway than in Indonesia.

  barriers to entry: Obstacles that make it difficult for a new firm to enter the market. The barriers can arise from technology (critical assets), from regulations (such as licensing requirements), or from the strategic behavior of incumbents. See also ease of entry.

  concentration: The equilibrium distribution of market shares resulting from the entry and growth of new firms versus the exit and mergers of existing firms. Concentration can be measured either as market share of top n firms (CRn, with n = 4, 8 …), or with the Herfindahl-Hirschman index (HHI).

  constant price GDP: See real GDP.

  consumption of fixed capital (CFK): See depreciation.

  cost of goods sold (COGS): An accounting item that refers to the direct costs of production. In manufacturing it includes the intermediate inputs (such as raw materials and energy) as well as the wages of production workers. It does not include R&D expenditures or the wages of administrators and researchers.

  demand curve: A downward-sloping line showing the relationship between the price of a good or service and the quantity that buyers are able or willing to purchase at that price.

  depreciation: The sum of wear and tear and obsolescence of the capital stock used in production; also called consumption of fixed capital (CFK).

  diversification: A method of managing risk by investing in varied firms, industries, and countries; also the fancy name for not putting all your eggs in one basket.

  duopoly: Oligopoly with two dominant firms.

  ease of entry: An antitrust and merger-approval concept to gauge the ability of future competitors to impose meaningful constraints on a merged firm. It requires timeliness (less than two years to plan entry and have a significant market impact), likelihood (profitability under premerger prices), and sufficiency (adequate knowledge of the market and financial resources to withstand aggressive pricing by a merged firm).

&nbs
p; economies of scale: A situation in which the average cost of production declines when production increases for a given good or service. The simplest example is that of a fixed cost: when output increases, the fixed cost is spread among more units and the average unit cost falls. See also network externalities.

  economies of scope: Economies of scale applied to the diversity of goods and services. A simple example is a retail location offering more than one product, such as a gas station that also sells coffee.

  efficiency (Pareto): A situation is Pareto-efficient (named for the Italian economist Vilfredo Pareto) when no single person or business can be made better off without decreasing the welfare of another. When an equilibrium is not Pareto-efficient, economists typically get agitated and try to fix it.

  elasticity: The change in one variable in response to a unit increase in another variable. For instance, the elasticity of tax revenues is the percent increase in tax collections for a one percent increase in GDP.

  elasticity of demand: The percent decline in the quantity of a good demanded in response to a one percent increase in the price of the good. If the elasticity is 2, consumers buy 20 percent fewer goods when the price increases by 10 percent.

  endogeneity bias: When people are proactive and react to their environment, endogeneity bias is the result. For example, people go to see a doctor when they feel sick; companies invest when they are confident in the demand for their products; corporations lobby when they have something to ask for or when they feel threatened. Endogeneity makes correlations difficult—sometimes impossible—to interpret. It is the fundamental issue in empirical economics.

  equilibrium: A situation that is stable for a period of time because the choices of economic agents are consistent with each other, and the budget constraints add up. A simple example of equilibrium is a market where the price adjusts so that supply equals demand. A complicated example is the labor market, where the unemployment rate depends on a large number of decisions by firms, workers, and consumers.

  externality: A cost incurred or a benefit received by one who did not create or choose the cost or benefit. British economist Arthur Cecil Pigou argued that government should impose taxes to correct negative externalities, such as a carbon tax to address the problem of climate change. See also network externality.

  fintech: Digital innovations in the financial services industry.

  free entry: The ability of new firms to enter a market and begin producing and selling a product without interference from regulatory agencies or dominant firms.

  gross domestic product (GDP): The total value of all the final goods and services produced within the borders of a country during a year. See also GDP per capita; nominal GDP; real GDP.

  GDP per capita: Gross domestic product divided by population. For example, US GDP was $20.5 trillion in 2018. US population was about 327 million. US GDP per capita was therefore $62,700.

  growth, real per capita: The growth of real GDP per capita. It is the starting point for analyzing changes in living standards. For instance, US real GDP increased by about 3 percent in the first quarter of 2019, as nominal GDP was up 3.8 percent and prices were up 0.8 percent. Since US population growth is around 0.7 percent, real per capita growth is about 2.3 percent. See also nominal GDP; real GDP.

  Herfindahl-Hirschman index (HHI): A measure of market concentration, computed as the sum of the squared market shares of the firms competing in the particular market.

  Horizontal merger: A merger between competitors at the same level of production and distribution of a good or service. It can have unilateral effects from the disappearance of competition between the products of the merged firms and coordinated effects from decreasing competition with other producers in the same market. See also vertical merger.

  income: For households, the sum of labor earnings and capital income. For firms, see profit margin; profit rate.

  Industrial Revolution: A rapid major alteration in an economy fueled by widespread advances in technology. The advances of the First Industrial Revolution were in mechanical production, beginning in Britain around 1780 with mechanized spinning and later iron manufacturing, fueled by coal and steam power. The Second Industrial Revolution was marked by advances in science and the mass production of goods (think of Ford’s Model T). Around 1870, transportation and communication networks (railroad, telegraph) were expanded and utilities (gas, water, and electrical power) established. Major inventions included the telephone, fertilizer, and internal combustion engines. The Third Industrial Revolution was the Digital Revolution: semi-conductors (1950s), then mainframe computers, personal computers, and the internet. Many argue that we are entering a Fourth Industrial Revolution, with major advances in genetics, medicine, and artificial intelligence.

  labor share: The share of GDP that accrues to labor instead of capital. The labor share is typically between 0.6 and 0.7, depending on the details of the calculation.

  law of one price (LOOP): The hypothesis that identical goods should sell for the same price in different countries when the prices are expressed in units of the same currency. It is more likely to be true when shipping and distribution costs are small.

  liquid asset: An asset that can be converted to cash without impacting its value.

  lobbying: The attempt to influence a politician or a public official. It can be benign—sharing relevant information between businesses, regulators, and politicians—but it can also involve rent-seeking and even lead to corruption.

  loss-leader pricing: The strategy of a firm that sells a product at a loss in order to attract customers and stimulate the sales of other, more profitable goods and services.

  market power: The ability of a firm to raise its price over its marginal cost (the cost of producing the last unit sold). Market power increases the firm’s profits at the expense of its customers but might be necessary to recoup sunk costs. Market power depends on the elasticity of demand and the nature of competition in the market.

  market share: The ratio of a firm’s revenues over the total sales in that market.

  mergers and acquisitions: Legal transactions that lead to the consolidation of two or more entities. An acquisition is when one company buys another entity. The company becomes the new owner and the entity disappears. The acquisition can be friendly or hostile. A merger of equals happens when two firms of similar size combine forces. The shares of both companies are replaced by newly issued stocks of the joint company. See also horizontal merger; vertical merger.

  merger review: Federal review of mergers and acquisitions between large firms. In the US, it is typically performed by the Department of Justice or by the Federal Trade Commission; in the EU, by the Directorate-General for Competition.

  monopoly power: Monopoly power is a general term that refers to market power by a single firm, even when it has a few competitors. See and compare with pure monopoly.

  monopsony power: A situation in which a buyer has market power, such as when a firm is the only large employer in a town.

  moral hazard: A situation in which the provision of insurance or safety nets leads to reduced efforts or higher risk-taking behavior. For instance, unemployment or disability insurance can reduce individual incentives to work.net asset value (NAV): The value of a fund’s assets minus the value of its liabilities. A floating NAV fluctuates, whereas a fixed NAV does not.net investment: Investment expenditures minus depreciation. Net investment measures the growth of the capital stock.net present value (NPV): The value of future cash flows, discounted and adjusted for risk.net sales: See revenues.

  network externality: A form of synergy whereby the value of belonging to a network increases when the number of users on the network increases. It can lead to the emergence of a dominant firm.

  nominal GDP: Gross domestic product expressed in local currencies (dollars, euros, yuan, etc.). It can be converted into the same currency (usually dollars) using exchange rates.

  operating income: The basic measure of profits from opera
tion, defined as sales (revenues) minus cost of goods sold (COGS) and selling, general, and administrative expense (SG&A). Just like earnings before interest and taxes (EBIT), it ignores taxes and interest payments. EBIT, however, also includes non-operating income.

  payout rate: The ratio of the flow of dividends and share buybacks over the stock of capital.

  predatory pricing: The strategy of a firm that sets low, unsustainable prices in order to drive its competitors out of business.

  premerger notification: Application by the parties involved in a merger or acquisition for a formal review of the process by the Federal Trade Commission and Department of Justice.

  price discrimination: The sale of identical goods or services at different prices to different customers.

  product market regulation (PMR) index: A measurement of regulations in the market for goods and services, including regulatory barriers to firm entry and competition.

  profit margin: A firm’s profit over total sales, measured in percent.

  profit rate: The ratio of income net of depreciation over the stock of capital at the beginning of the year.

  purchasing power parity (PPP): A measurement tool to compare standards of living between countries by using the price of a common basket of goods and services. PPP can be used to define exchange rates and to compare real income per capita. The Big Mac index is PPP using the price of Big Mac sandwiches.

  pure monopoly: A situation in which there is only one seller in a market, such as when a firm is the only supplier of a particular product in a particular location. Cases of pure monopoly are relatively rare.