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DAILY 25/11/05

NBER Papers on Declining GDP Volatility and the Bias in the CPI
Robert Gordon explores the reasons for the decline in business cycle volatility since the mid-1980s:
What Caused the Decline in U.S. Business Cycle Volatility?, by Robert J. Gordon , NBER WP 11777, November
2005: Abstract This paper investigates the sources of the widely noticed reduction in the volatility of American
business cycles since the mid 1980s. Our analysis of reduced volatility emphasizes the sharp decline in the
standard deviation of changes in real GDP, of the output gap, and of the inflation rate. The primary results of the
paper are based on a small three-equation macro model that includes equations for the inflation rate, the nominal
Federal Funds rate, and the change in the output gap. The development and analysis of the model goes beyond
the previous literature in two directions. First, instead of quantifying the role of shocks-in-general, it decomposes
the effect of shocks between a specific set of supply shock variables in the models inflation equation, and the
error term in the output gap equation that is interpreted as representing IS shifts or demand shocks. It
concludes that the reduced variance of shocks was the dominant source of reduced business-cycle volatility.
Supply shocks accounted for 80 percent of the volatility of inflation before 1984 and demand shocks the
remainder. The high level of output volatility before 1984 is accounted for roughly two-thirds by the output
errors (demand shocks) and the remainder by supply shocks. The output errors are tied to the papers initial
decomposition of the demand side of the economy, which concludes that three sectors - residential and inventory
investment and Federal government spending, account for 50 percent in the reduction in the average standard
deviation of real GDP when the 1950-83 and 1984-2004 intervals are compared. The second innovation in this
paper is to reinterpret the role of changes in Fed monetary policy. Previous research on Taylor rule reaction
functions identifies a shift after 1979 in the Volcker era toward inflation fighting with no concern about output,
and then a shift in the Greenspan era to a combination of inflation fighting along with strong countercyclical
responses to positive or negative output gaps. Our results accept this characterization of the Volcker era but find
that previous estimates of Greenspan-era reaction functions are plagued by positive serial correlation. Once a
correction for serial correlation is applied, the Greenspan-era reaction function looks almost identical to the pre1979 Burns reaction function! [Open link to conference version of paper.]
Robert Gordon and Todd vanGoethem ask if there is a downward bias in the CPI:
A Century of Housing Shelter Prices: Is There a Downward Bias in the CPI?, by Robert J. Gordon, Todd
vanGoethem, NBER WP 11776, November 2005: Abstract Tenant rental shelter is by far the most important
component of the CPI, because it is used as a proxy for owner-occupied housing. This paper develops a wide
variety of current and historical evidence dating back to 1914 to demonstrate that the CPI rent index is biased
downward for all of the last century. The CPI rises roughly 2 percent per year slower than quality-unadjusted
indexes of gross rent, setting a challenge for this research of measuring the rate of quality change in rental
apartments. If quality increased at a rate of 2 percent per year, the CPI was not biased downward at all, but if
quality increased at a slower rate of 1 percent per year, then the CPI was biased downward at a rate of 1 percent.
Our analysis of a rich set of data sources goes backward chronologically, starting with a hedonic regression
analysis on a large set of panel data from the American Housing Survey (AHS) covering 1975-2003. Prior to
1975, we have large micro data files from the U. S. Census of Housing extending back to 1930. In addition to the
hedonic regression data, we stitch together data on the diffusion of important quality attributes of rental units,
including plumbing, heating, and electrification, over the period 1918-73. Our final piece of evidence is based on
a study of quality-adjusted rents in a single local community, Evanston IL, covering the period 1925-99. Our
overall conclusions are surprisingly consistent across sources and eras, that the CPI bias was roughly -1.0
percent prior to the methodological improvements in the CPI that date from the mid-1980s. Our reliance on a
wide variety of methodologies and evidence on types of quality change and their importance, while leaving the
outcome still uncertain, at least in our view substantially narrows the range of possibilities regarding the history
of CPI bias for rental shelter over the twentieth century. [Open link to earlier version.]
Interview in Die Welt, La Stampa and Libration
Interview with Jean-Claude Trichet, President of the European Central Bank published on 24 November 2005
and conducted by Anja Struve (Die Welt), Stefano Lepri (La Stampa) and Jean Quatremer (Libration).
The publication of the text was authorised by Die Welt, La Stampa and Libration. The interview has not been
published in full length in all three newspapers.
Q: You have announced that there is to be a very rapid rate increase, presumably at the next meeting of the
Governing Council on 1 December. Why has the situation passed so quickly from an "appropriate level of
interest rates" to such an alarmist position, when underlying inflation (i.e. excluding energy prices) remains well
below 2%?

A: At the last press conference I had stressed that we could increase rates at any time as the risks had increased.
And all the observers noted that our vigilant stance had strengthened.
Q: In the view of the ECB, inflation risks have increased, which gives cause to think that you are going to
increase interest rates. However, in the three largest countries of the euro area underlying inflation (i.e. excluding
energy prices) remains well below 2%. Why such alarmism?
A: The Governing Council is not alarmist. It is vigilant. It is faithful to its mandate, which is to guarantee price
stability. It knows that this is what is required of it by 311 million European citizens of the euro area, who
strongly call for price stability. It knows that this is what is expected of it by European and global investors and
savers who place their trust in the ECB. The risks of a price rise in the medium term have increased. These risks
must be prevented from materialising. Prevention is always better than cure, in the best interest of growth and
job creation.
Q: This is the first time in the ECBs history that such a clear statement has been issued in advance. Did you
discuss this at the Governing Councils meeting on 17 November, which does not normally focus on monetary
policy? Was there a consensus in favour of this rate increase?
A: The ECB has always been very predictable in its interest rate decisions. Academic research has generally
found the ECB to be the most predictable, together with the US Federal Reserve System. I have conveyed the
sentiment of the Governing Council at a time when doing so was useful for everyone, for public opinion, for our
institutional partners, who made a lot of comments, and for the markets.
Q: Why such a hasty and unusual announcement? What triggered this hardening of the tone of the Governing
Council in recent days?
A: It was my duty and responsibility as president and spokesperson of the Governing Council to speak in a
context where too many voices, outside of the Governing Council, were talking about monetary policy and
interest rates.
Q: You told the Parliament in Brussels that a rise in interest rate rise would be moderate and that it would not be
the first in a series of rises. Why start by imposing such a restraint if the inflation risks have increased, according
to the ECB? Are you not afraid that it could be interpreted as an unconvincing and very hesitant step?
A: I said that we were not, ex ante, planning a series of rises. In the past we have always, at any time, fixed
interest rates at the necessary level to guarantee price stability in the medium term on the basis of all the data
available to us. Everyone can rest assured that we will continue to do so. Neither more, nor less than that.
Q: Are you not afraid that you will halt the fragile recovery of growth that is emerging?
A: Preserving and maintaining price stability preserves confidence. Preserving confidence is essential for growth
and employment. In the monetary and financial sphere we are both the guardians and the guarantors of
Q: You have kept interest rates unchanged for 32 months. You have therefore kept your cool longer than most
central bankers in Europe, with the exception of Karl Blessing, the former President of the Deutsche
Bundesbank. Are you on track to beat his record?
A (laughs): Indeed, for two and a half years we have kept rates at their lowest level since the Second World War.
However, we have never promised anyone that we would not change them. Throughout this entire period, which
has proved complex and difficult, we have remained vigilant, upheld our credibility and firmly kept expectations
regarding future price rises in line with our definition of stability.
Q: But for some weeks contradictory statements from within the Governing Council have been multiplying. It
seems that the ECB is divided into hawks, who would like to increase rates immediately, and doves, who are
more concerned about growth. Is this why the ECB has not moved up to now?
A: That is not the case. The Governing Council is not divided. On the contrary, I believe it is very much united.
And, naturally, it is the President, as spokesperson, who states the Governing Councils position. The ECB has

never delayed taking a decision. And we have proved that we are able to make extremely quick decisions,
particularly at the time of the dramatic events on 11 September 2001.
Q: Is the euros fall against the dollar a further cause for concern, since this increases the risk of imported
A: I do not comment on exchange rate movements unless I have a message to deliver. That is not the case at
Q: How will a rate increase, which will drive up the cost of money, affect the price of imported petrol, which is
principally fuelling inflation currently?
A: It is important that price rises today do not turn into persistent inflation tomorrow and the day after. This is
why we are particularly concerned that there should be no second-round effects: economic agents who fix the
prices of goods and services, on the one hand, and social partners who fix the price of salaries and wages, on the
other, must not incorporate in all their decisions the assumption that price rises due to petrol will be persistent.
That is the objective of the ECB and, moreover, of all the central banks.
Q: What you say was true in the past, when second-round effects occurred immediately after petrol price rises,
but that is no longer the case, nor has it been for many years.
A: Although we can clearly see that the risks have increased, thankfully we have not seen these second-round
effects materialise which would be a catastrophe for all because inflation would become persistent. However,
we must not wait for these effects to materialise before countering them, as it would then be an extremely
difficult and long task to eradicate them. I think that if there have been no second-round effects, it is as a result of
great credibility: economic agents know that we are here precisely in order to prevent persistent inflation by
taking the necessary decisions.
Q: Will the reserve army of the unemployed who check any pressure on wages also prevent second-round
A: We have known times when both stagnation and inflation, unemployment and inflation existed
simultaneously. Unfortunately the two phenomena can coexist.
Q: So is there a risk of stagflation?
A: I dont think so at all. As we expected, growth has accelerated in the second half of this year. And we are here
to maintain price stability.
Q: Jean-Claude Juncker, the president of the Eurogroup, has called upon you not to make any hasty gestures.
How do you view the word hasty? Should you not defend yourself vigorously against such suggestions?
A: Jean-Claude Juncker knows how we think as he is invited to the meetings of the Governing Council and
because I myself am invited to meetings of the Eurogroup. Everyone knows, and he foremost, that we are totally
independent as required by the Treaty. We are responsible to the 311 million inhabitants of the euro area for price
stability, and the preservation of our credibility vis--vis Europe and the world is essential for growth and the
creation of jobs in Europe.
Q: But how can you be so sure that European politicians will not one day decide to change the mandate of the
ECB, as the Italian Prime Minister, Silvio Berlusconi, has already proposed?
A: I do not fear this happening at all, because our mandate is clear. Moreover, at the time of the discussion of the
Constitutional Treaty, the decision was taken to leave the ECBs mandate unchanged. Why? Because price
stability is one of the necessary conditions for sustained growth and job creation. That is also why Europeans
expect their central banks to ensure price stability: to better fulfil the conditions for sustained growth.
Q: Last week, Ben Bernanke, who has been nominated for the post of Chairman of the Federal Reserve, speaking
before the Banking Committee of the US Senate, called the ECBs mandate one-dimensional because it is
based solely on inflation and not on growth.

A: You are only quoting part of his reply, in which he praises American law in the same way that I have just
praised the European Treaty! However, in another part of his reply he states, and I quote, that by maintaining
inflation at a low and stable level () you can create more stable, more substantial growth in employment. The
current Fed chairman said, and says, the same thing; I am of the same opinion.
Q: Although inflation is under control, growth in the euro area is far from being healthy and sustained. What
exactly is not working?
A: Growth has clearly been disappointing in recent years. But did you know that, on average, growth in the euro
area has been slightly better since the introduction of the euro from 1999 to 2004 than its average level in the
seven years preceding the introduction of the euro from 1992 to 1998 (1.9% against 1.8%)? Why is there
insufficient growth? This is because we have not undertaken the necessary reforms everywhere in Europe.
Countries which have implemented reforms have experienced more rapid growth. Just look at Ireland and
Finland in the euro area; take Denmark, which follows exactly the same monetary policy as us; outside Europe,
consider, for example, Canada; look at Australia.
Q: But the ECB is more concerned about inflation than growth, isn't it?
A: As I said, in accordance with the Treaty, our primary responsibility is price stability. This is because it is a
necessary condition for sustained growth. If investors and savers all over the world deemed that we were no
longer delivering price stability, all of our medium and long-term market interest rates would rise enormously,
because they would incorporate the future price increases. These market rates are therefore very important for
the economy, since they are the ones that businesses look to for their investments. That is why I believe, along
with all my colleagues, that by remaining faithful to our stability mandate, to which the households are so
profoundly attached, we are working for sustained growth and job creation.
Q: Are the governments therefore responsible for the anaemic levels of growth?
A: No, we are not singling out anyone. I simply note that, unfortunately, all of us political and monetary
leaders, social partners, academics, etc. are still not very effective at convincing public opinion that the
implementation of such structural reforms will be beneficial for all. In political democracies the need to convince
public opinion is essential.
Q: How can we halt the deterioration in public finances now that the Stability and Growth Pact has failed to
fulfil its role?
A: We think that the Stability and Growth Pact is an essential element of Economic and Monetary Union. It
compensates for the absence of a European government and federal budget and thus ensures cohesion within the
area in which the single currency is used. This is why we insist that it should be rigorously applied. It is also in
line with the wishes of people who today do not have a great deal of confidence in a number of budgetary
policies. When confidence is lacking, people consume little for fear of future taxes, and businesses do not invest
enough for the same reasons. Sound management of public finances over the medium term is reassuring and it
boosts confidence, promotes growth and leads to more jobs.
Q: Are you at all worried by the German governments plan to raise VAT?
A: I do not wish to comment on the decisions taken by a specific government. In general, I would say that the
faster deficits are reduced, the faster confidence is restored, and the more deficits are reduced as a result of the
decrease in public spending in proportion to GDP, the faster and more lastingly confidence returns.
Q: Are you going to tighten your loan conditions for countries whose public debt is too large, as you are alleged
to intend?
A: I have previously re-stated our position regarding the bonds that we accept as collateral for our monetary
operations. There has been no change in our behaviour since 1999. We only accept as collateral for our financial
market activities private and public sector bonds with a rating that is equal to or higher than A (including A-).
Q: Is it the case that stating what you are doing even if it does not change anything is a way of getting a message

A: Again, I restated our position because I was asked to do so; people are free to draw their own conclusions.
Q: Are you aware that certain political allies of Governor Fazio have decided not to accept collegiate banking
A: The Governing Council of the ECB has taken a stance in favour of a collegial approach because we believe
that it is an important way of ensuring the smooth running of prudential supervision as a whole.
Q: Despite the banking scandal in Italy, the ECB did not even apply its own code of conduct. Just when should it
be applied if not in a case such as this, which could even have repercussions for the ECBs credibility?
A: The Governing Council has said very clearly all that it has to say regarding the Banca dItalia.
Q: Otmar Issing will leave the Executive Board in May 2006. Are you afraid that the political powers will take
advantage of this to appoint a successor who will be more sympathetic to their opinion?
A: No, I have complete faith in the decision-making mechanism, which requires the Governing Councils
opinion, the European Parliaments opinion and the unanimous decision of the Heads of State and Government
Q: Do you think it is important whether or not Mr Issings successor is German?
A: Otmar Issing is and has been a remarkable member of the Executive Board and Governing Council. It falls to
the Council of the European Union, that is to say the twelve ministers, to nominate a high-quality candidate. This
is the opening stage of the procedure. As I have already told you, I have confidence in this procedure.
Q: The rejection of the European Constitution has deprived the European Union of any political project. Can the
single currency survive when the deepening of the Union has been stalled?
A: Europe can count on the ECB. We have shown that we can get through difficult and turbulent periods,
including those caused by referendums, by maintaining the world-wide credibility of the European signature.
From the ECBs perspective, Europe has not come to a standstill. Twelve countries already share the euro and the
currencies of seven others (Cyprus, Denmark, Estonia, Latvia, Lithuania, Malta and Slovenia) participate in the
European exchange rate mechanism. That makes nineteen in total! For many of these countries, careful
preparation for entry to the euro is the great challenge of the day. We are involved in a very dynamic process. At
the political and constitutional level, we are clearly in a meditation phase, but I do not think that this will last.
Europe will resume its forward path.
As the world becomes accustomed to the American way of life, Americans are tuning out the rest of the world. US citizens have paid less
and less attention to foreign affairs since the 1970s, writes journalist Alkman Granitsas. The number of university students studying
foreign languages has declined, and fewer Americans travel overseas than their counterparts in other developed countries. News
coverage of foreign affairs has also decreased. Why are Americans withdrawing from the global village? A continuing immigration boom
may be one factor; with millions of foreigners trying to get in, Americans may think the rest of the world has little to offer. In addition, a
rising income gap between the US and most of the worlds population makes some Americans hesitant to travel overseas. Finally,
economic prosperity leads many to pay less attention to politics, especially international affairs. With an increasingly uninformed
electorate, can the worlds superpower be trusted to shape a responsible foreign policy? YaleGlobal

Americans are Tuning Out the World

When the world comes to their shore, US citizens are increasingly less interested in foreign affairs

Alkman Granitsas
YaleGlobal, 24 November 2005

ATHENS: For all the talk about a global village, there are
actually two communities in the world today: Americans
and everyone else. The average Frenchman, Brazilian, or
Pakistani is becoming more attuned to the American way of
life, but Americans themselves are increasingly tuning out
the rest of the globe. At a time when US power, benefiting
from globalization, is unchallenged in the world, a
disinterested electorate could be a recipe for trouble.
Foreigners have long bemoaned the "isolationist" attitude
of Americans safely protected by two oceans and their
tabula rasa history. But over the last several decades, that
isolation has deepened. Americans now pay less attention
to international affairs, and read less foreign news than at
any time in the last two generations. Relative to the global
boom in international travel, tourism, and business, fewer Disengaged at the top: Americans celebrate their
preeminence, but care less and less about the rest of the
Americans go overseas or study a foreign language at
university. The truth is
that Americans are
becoming relatively less not more
engaged with the world
in general.
A few facts. Since the
less and less attention
from presidential
Americans used to rank
facing the nation. Since
the 2004 elections, the economy has been ranked first.

early 1970s, the American public has paid

to foreign affairs. According to Gallup polls
election years 1948 through 1972,
foreign affairs as the most important issue
then, however, with the single exception of

Over the same period, the percentage of American university students studying a foreign language has
steadily declined. According to a report funded by the US Department of Education,in 1965, more than
16 percent of all American university students studied a foreign language. Now only 8.6 percent do.
It has long been known that fewer Americans have passports, and US citizens travel less than their
counterparts in other developed economies. And while a record 21 percent of all Americans now have
passports and are traveling more, the number going overseas in the past 20 years not just to
neighboring Canada and Mexico has grown at a slower rate than the number of overseas visitors to
America or the growth in international tourism in general. And indeed, during the late 1980s and early
1990s, the number of Americans even applying for a passport declined in several years.
American media coverage of foreign affairs has also been
diminishing. For example, according to a 2004 Columbia
University survey, the presence of foreign news stories in American
newspapers has been dropping since the late 1980s. In 1987,
overseas news accounted for about 27 percent of front page stories
in American newspapers about the same as a decade earlier. By
2003, foreign news accounted for just 21 percent of front page
stories, while coverage of domestic affairs more than doubled over the same period. On television, both
the number of American network news bureaus overseas and the amount of air-time spent on foreign
news fell by half in the 1990s.

Why are Americans progressively tuning out the rest of the world? The reason is twofold. But both
confirm the cherished belief of most Americans: that their country is a "shining city on the hill." And
the rest of the world has relatively little to offer.
Consider first, that for the past 45 years, Americans have witnessed a massive immigration boom.
Since 1960, more than 20 million immigrants have come to the United States the greatest influx of
newcomers in the last hundred years, surpassing even the wave of immigrants that arrived in the first
three decades of the 20th Century. Two-thirds of these newcomers
more than 15 million have come in just the past 25 years.
That they should come bears out the myth that America is a
melting pot of peoples. Indeed, the iconic images of the first
Plymouth Rock Pilgrims and the Ellis Island immigrants of the
early 1900s, are at the very center of American popular mythology.
More recently, news footage of Mexican-Americans rushing the
fences on the southern borders shows that America attracts all
And every single American from the mid-western blue collar worker to the pedigreed New England
blueblood knows their forebears came from someplace else. Chances are they've met or know
someone the Bangladeshi working at the 7 Eleven, the Chinese scientist on TV, the Somali cab driver
at the airport - who has come even more recently.
With the whole world apparently trying to get to America, the average American can only ask: why
look to the rest of the world? After all, why would everyone try to come here if there was anything
worthwhile over there? It is telling that according to a 2002 National Geographic survey, 30 percent of
Americans believed the population of America to be between 1 and 2 billion people. For most
Americans, it must seem like everyone is rushing the fences these days.
The second reason is that for much of the last two decades most
(but not all) Americans have seen their economic well-being grow
relative to the rest of the world. Through much of the 1990s,
American consumer confidence and real disposable income have
risen at their fastest levels since the relatively golden age of US
economic growth of the 1960s. These have been matched by
perceptions of increased wealth from a stock market rally that, with interruptions, lasted from the
early 1980s until three years ago.
Why should that matter? Because since the days of ancient Rome, it is an axiom of political science
that economic well-being dulls the appetite of citizens to participate in civil affairs. It is something that
de Tocqueville observed more than a hundred years ago.
"There is, indeed, a most dangerous passage in the history of a democratic people," de Tocqueville
observed. "When the taste for physical gratifications among them has grown more rapidly than their
education and their experience of free institutions ... the discharge of political duties appears to them
to be a troublesome impediment which diverts them from their occupations and business."
Long before 9/11, the Asian tsunami, SARS, the bird flu, and the relatively weaker dollar, Americans
were already growing less interested in the rest of the world. Since then, they have found even more
reasons to tune out.

The implications, however, are disturbing. Because of America's pre-eminent position in world affairs
-and its role in "globalization," its foreign policy matters more than any other country on earth. But
can America shape a responsible foreign policy with such an uninformed electorate? The world may be
turning into a "global village," but the average American has moved to the suburbs.
Alkman Granitsas is an American journalist who has worked overseas in Asia and Europe for over 10
years. He is currently based in Athens.