more Economic Geography

Recessions spread geographically.

This picture of the effects of the 1985 drop in oil prices is interesting. The light green states in 1985 are oil producing States put into recession by the change in oil price. The sub-national recession spreads out from those States but never becomes national.
1985 oil price drop

Looking at recessions geographically is interesting because it reframes the issue of business cycles as one of distribution rather than efficiency. A reduction in the price of oil was great on average, but crappy for those live just west of the Mississippi.

The great contribution of RBC models was to repair efficiency in cycling economies. Meanwhile, the new Keynesians try to undo this result, but images like the one above suggest economists should spend more time on the distributional aspects of business cycles.

Notice, this is an invitation to discuss distributional issues without the usual normative baggage. Its just a fact that various supply shocks induces recessions in some places and booms in others.

9 thoughts on “more Economic Geography”

  1. With purely competitive analysis and the usual functional forms, it’s usually true that the 2nd Welfare Theorem hold and therefore there are no distributional issues, if government plays its part as scripted.

    On the other hand I can’t but think of using consumption or wealth, rather than income, as the variable of interest, in which case the fluctuations should be far less dramatic.

    If there’s no “home (state) bias” then people in Texas (for example) should diversify their portfolios until they’re insured again oil risk.

  2. The second welfare theorem requires redistribution to get the efficient outcome you want, i.e. this isn’t the droid you’re looking for…

    So, the fact that there was a sub-national recession implies people aren’t well diversified? Why would that be? Also, if diversification was enough to mediate business cycles, then why do we see real business cycles at the national level? You say we can insure against the most famous example of a negative supply shock, if so, what’s a supply shock in RBC models?

    Without the advent of RBC models, I wouldn’t have been able to ask these questions. This is why I pray to the holy trinity (Lucas, Kydland and Prescott, praise be upon them) every night before I go to bed.

  3. That was exactly my point. In the baseline RBC model, to get the Representative Agent, you must assume perfect redistribution (as to get the SWF).

    Re: diversification… My point was regarding system risk vs. diversifiable risk.

    In a perfect setting, you can always diversity as to be safe from everything except system risk (i.e. the risk to the ENTIRE economy).

    Bad schocks in national-level models = system risk.

    Shocks to one market/one sector = diversifiable. Don’t put all your eggs in the same basket/state.

    If you live in Kansas, there’s no reason that your income to correlated with to the Kansas’ GDP.

    Where am I going wrong?

  4. By “distribution,” do you mean actual physical distribution of physical goods and commodities? Or is “distribution” one of those reserved words that has a special, different meaning to economists?

    If it’s actual physical distribution of oil, then this map would be more informative if overlaid with a map of oil wells, pipelines, refineries, and docking terminals. Did Arkansas dodge this recession because less of their state economy was tied to oil production?

    Some economic specialization seems unavoidable, especially if you’re sitting on scarce natural resources.

  5. “this was exactly my point” It was? RBC models have the economy always in equilibrium and by the 1st welfare theorem that equilibrium is optimal. (This is weird for most people to get their head around, including me, because people tend to use their past outcomes to decide whether or not they’re better off today, but this isn’t required for Pareto optimality.)

    Re: diversification… I don’t think you’re going wrong anywhere. I think this is an interesting line of inquiry though. So, by your logic, national shocks can be diversified away in world markets? why would one artificial political unit, the nation, have precedence over others in determining interesting economic questions?

    Otherwise, supply shocks are just the effects of incomplete markets on the national or sub-national economy. By your reasoning, RBC can only be used to analyze world-wide business cycles OR it begs the question of distribution.

    In any case, there’s a much more down to earth interesting economic question to worry about. Texas had a recession in 1986. Isn’t it an interesting economic concern that those geographically near Texas had one too and those geographically separated didn’t? Isn’t the issue especially interesting given 1986 is usually seen as a boom time for the U.S. as a whole?

    swong, by “distribution” I’m referring to consumption or income distribution. My point in the post is that things that are normally thought of as good things (shocks that lower the price of oil), are a boon to most people but not everyone. Taking a look at the issue geographically makes this point pretty clear.

    Gabriel’s observation about diversification is important regarding your last sentence. If Texans were smart (heh), they’d have insured themselves against busts in oil prices (i.e. there shouldn’t have been a recession there in 1986). Specialization is unavoidable (and even fortuitous), but by Gabriel’s logic sub-national (or even national) recessions aren’t.

  6. I’m doing a post on this myself, a bit later.

    Local productivity shocks ought not translate to income shocks.

    By Arrow-Debreu logic you own a percentage of the aggregate economy and you diversity like crazy, and that percentage is given by your initial endowment, and so you only care about aggregate shocks.

    The relevant empirical puzzle here might be the “home bias”… With open financial/capital markets, saving and investment should not be particularly correlated. But they are.

  7. Seems like diversification is really only a dampening mechanism, then. Diversify enough, and a local shock is barely distinguishable from noise.

    If that’s the case, then wouldn’t sudden isolation from the trade network represent an additional threat?

  8. swong, that’s a great point. Besides home bias, there’s a number of reasons why there might be local supply shocks. Any explanation of sub-national recessions would have to explain their geographic dynamics. Louisiana went into recession, then Texas then New Mexico. Do Texan investors have a Louisiana-bias relative to New Mexico?

  9. I’ve been looking into this, trying to find angles for a post… I’ve been using that awful Sargent book.

    Basically, within a competitive setting, the consumption of an US state (or citizen!) will be a constant fraction of US income, regardless of the productivity shocks and other state variables.

    This means that a all-other-things-constant drop in productivity in Texas will decrease welfare in Texas but not as much as it would without integrated financial markets. The drop in welfare gets smaller and smaller as the size of a US state would get smaller compared with the entire economy. — For an individual household, which is small compared with the economy, you get de facto full insurance.

    With perfect competition you do a redistribution of initial endowment and from there on, for ever and ever, everything is optimal.

    The interesting part is why this is not the case in the Real World ™ and as you point out, home bias is just a part of that.

    International RBC models should be of interest here, but I know none and studied none so far. :-(

    Anyway, I gave up on the idea of a post… it could be either too technical or uninteresting.

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