WEBVTT

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- [Teacher] The path
from cause to effect

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is dark and dangerous,

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but the weapons
of econometrics are strong.

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Wield differences-in-differences
when witnessing parallel trends.

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♪ [music] ♪

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Masters of metrics

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look for convincing
ceteris paribus comparisons.

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The ideal comparison contrasts
treatment and control groups

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that look similar.

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But sometimes this sort
of comparability is elusive.

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When treatment and control groups

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evolve similarly
in the absence of treatment,

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even if from different
starting points,

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there's hope for causal inference.

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The weapon that exploits
parallel evolution,

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masters say "parallel trends,"

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is called differences-in-differences...

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- [Man whispering]
Differences-in-differences...

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- ...or DD for short.
- [Man] Alright.

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- Let's see how DD
can help us understand

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one of the most important
economic events

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in U.S. history.

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- [Joshua] Look back with me now
at the Great Depression --

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the worst economic catastrophe
our country has ever known.

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Unemployment hit 25% in 1933 --

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a level not seen before or since.

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Millions lost their homes
or their land.

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Suicide spiked, and hungry families

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relied on soup kitchens
and bread lines

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to keep from starving.

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- Economists argue fiercely

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over the causes
of the Great Depression.

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Most agree, however,
that a key piece of the puzzle

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is an epidemic of bank failures.

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This was before deposit insurance.

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So if your bank went bankrupt,
your savings disappeared with it.

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- [Cashier] Closing your account?

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- [Customer] Yes, sir.
I'm closing my account.

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I wouldn't leave a nickel
in this bank.

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- Faced with a banking crisis,
the Central Bank has a choice:

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lend freely to troubled banks

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or stand aside and refuse to lend.

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Lending freely to banks in trouble
is called "easy money."

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Refusing to lend
is called "tight money."

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- [Joshua] Monetarist masters
Milton Friedman and Anna Schwartz

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famously called
the Great Depression

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the "Great Contraction,"

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accusing the Federal Reserve

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of inflicting a misguided policy
of tight money

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on the nation's teetering
financial institutions.

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They argued that easy money

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would have kept
many banks in business,

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shortening the Great Depression.

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But others disagree!

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If banks are insolvent

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because of unwise
lending decisions,

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then bailouts just encourage
more foolishness.

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Economists called this problem
"moral hazard."

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The debate over bailouts
and moral hazard continues today.

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Should financial behemoth
Lehman Brothers

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had been allowed to fail
on the eve of the Great Recession,

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in an ideal world,
we'd answer this question

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by applying different Fed policies
to randomly selected regions.

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But we can still learn a lot

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by using differences-in-differences

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to compare trends across areas
with different monetary policies.

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- [Camilla] How's that even possible?

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Don't the same Fed policies
apply to all banks in the U.S.?

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- [Man] Yeah.
- Good question.

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The Federal Reserve System
is divided into 12 districts,

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each headed by a regional bank.

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Today, Fed policy is set
at the national level.

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But in the 1930s, regional Feds
could do pretty much as they liked.

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- [Man] Ah, interesting.

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- And here's what's
so awesome about that.

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In 1930, the Atlanta Fed,
running the 6th district,

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followed an easy money policy,

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sending wheelbarrows of cash
to rescue insolvent institutions.

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The St. Louis Fed,
running the 8th district,

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followed a tight money policy.

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"Let fail the foolish!"
they said in St. Louis.

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And so a natural experiment
in monetary policy was born.

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Even better, this is
a within-state experiment.

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The border between the 6th
and the 8th districts

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ran smack through
the middle of Mississippi.

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So northern Mississippi
had tight money,

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while southern Mississippi
had easy money,

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but under the same state laws
and banking regulations in both.

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- [Teacher] The treatment group

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is the district 6 part
of Mississippi,

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which had access to easy money
during the crisis.

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The control group

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is the district 8 part
of Mississippi,

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which had tight money
during the crisis.

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The key year
in our natural experiment

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was 1930.

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Caldwell & Company,

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a massive financial empire
in the South,

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came crashing down.

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Banking is a business
built on confidence and trust.

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The Caldwell meltdown
caused a panic

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that led to a widespread
bank run all at once.

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Depositors wanted their money back,

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causing banks to go bankrupt
and shut their doors.

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We'll use differences-in-differences

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to measure the effect
of contrasting monetary policies

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in response to the Caldwell crisis.

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This figure plots the number
of banks in Mississippi by year,

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for the 8th and 6th districts.

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Let's start in 1929,

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a year before the Caldwell crash.

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There are 169 banks
open in the 8th,

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and 141 banks open in the 6th.

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Over the next year,

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we see a similar handful
of banks fail, in both districts.

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The change in the number
of banks in operation

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is remarkably similar --

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that's what parallel trends look like.

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In November 1930, Caldwell crashes,

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and the panic begins.

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Banks failed frequently
in the 8th district,

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which had tight money.

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But the decline is slower
in the 6th district,

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which had easy money.

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Diverging trends in this period

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might be attributable
to easy versus tight money.

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In July of 1931, the 8th district
abandons tight money,

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so now both districts are easy.

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Parallel trends are restored.

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In a counterfactual world,

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where the 6th district
follows a tight money policy,

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what might have happened?

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If we extrapolate the trend
of the 8th district to the 6th,

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it would look like this.

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So the treatment-effective
easy money

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is how much the 6th district
deviated from the path

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implied by the 8th district trend.

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How many banks
did the easy money treatment save?

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This table reports data
for the treatment group, district 6,

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in the first row,

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and data for the control group,
district 8, in the second row.

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The first column shows
the number of banks in business

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before the crisis began in 1930.

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The second column shows 1931.

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This is the key period

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when each district
had differing monetary policies

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during the crisis.

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The rightmost column
reports changes within the district.

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District 6 lost 14 banks,
while district 8 lost 33.

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The mathematical formula
for the treatment effect is simple.

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We subtract the change in banks
in operation in the 8th district

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from the change in banks
in operation in the 6th.

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Hence, the name
"differences-in-differences."

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-14 minus -33 equals 19.\]

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We estimate that 19 banks
were saved by easy money.

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In practice, tables and figures
like those shown here

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are the beginning
rather than the end

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of a DD analysis.

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The problem of how to gauge

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the statistical significance
of DD estimates

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turns out to be exceedingly tricky,

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and a regression is typically
part of the solution.

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The key assumption
behind a valid DD analysis

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is that of parallel trends.

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Recall the principle
of ceteris paribus.

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Our ideal comparison
would have the two districts

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experience an identical
business environment,

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except for one factor:

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easy or tight money.

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Both districts would have
identical types of customers

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who would go bankrupt
at exactly the same rate.

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The skill of their employees
would be equal, and so on.

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Perfect ceteris paribus comparisons
would allow us to clearly see

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the causal effect
of different Fed policies.

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In this case, that's not possible.

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But the idea of parallel trends
is based on a similar concept.

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If we see that the two regions
experience similar trends

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in the number of banks over time,

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in the absence of treatment,

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we can assume
they are good comparisons.

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We see that the two districts
move in parallel,

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both before the crisis and after,

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when they have the same Fed policy.

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The only time the districts
behave differently

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is when the Fed policy is different.

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In view of this,

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Fed policy is a likely cause
of diverging trends

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from 1930 to 1931.

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But we should also check
for other changes

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unique to northern Mississippi.

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- [Man] Huh?
- What do you mean?

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- [Teacher] Imagine that bad tornadoes

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hit northern but not
southern Mississippi in 1930.

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These tornadoes devastate farms,

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causing farmers
to default on loans,

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which drives their banks
out of business.

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Then the 6th and 8th districts

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would differ in not one
but two ways:

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Fed policy and weather.

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And we'd have trouble
identifying Fed policy

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as the causal factor
behind increased bank failures

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in the 8th.

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- [Man] Ceteris is not paribus.

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- DD credibility lives or dies

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with the claim that the only reason

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northern Mississippi
was special in 1930

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is differing regional Fed policy.

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We're in DD heaven with strong,
visual evidence of parallel trend.

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- In general, the first step
in evaluating whether to use DD

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is usually this type of visual
confirmation of parallel trends

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outside of the period,

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when we expect to see
a treatment effect.

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The treatment in our example

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is easy money
in the face of bank failures.

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Metrics masters use DD
to explore effects of many policies,

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like the minimum legal drinking age,

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and environmental changes,
like access to clean water.

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In our next video,

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we'll see an example
of how regression is used

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to implement a DD approach.

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by taking a few quick
practice questions.

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Or if you're ready,
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♪ [music] ♪