- [Woman] The path
from cause to effect
is dark and dangerous,
but the weapons
of econometrics are strong,
wield differences-in-differences
when witnessing parallel trends.
♪ [music] ♪
Masters of metrics
look for convincing
ceteris paribus comparisons.
The ideal comparison contrasts
treatment and control groups
that look similar.
But sometimes this sort
of comparability is elusive.
When treatment and control groups
evolve similarly
in the absence of treatment,
even if from different
starting points,
there's hope for causal inference.
The weapon that exploits
parallel evolution,
masters say "parallel trends,"
is called differences-in-differences...
- [Man whispering]
Differences-in-differences...
- ...or DD for short.
- [Man] Alright.
- Let's see how DD
can help us understand
one of the most important
economic events
in US history.
- [Joshua] Look back with me now
at the Great Depression --
the worst economic catastrophe
our country has ever known.
Unemployment hit 25% in 1933 --
a level not seen before or since.
Millions lost their homes
or their land.
Suicide spiked, and hungry families
relied on soup kitchens
and bread lines
to keep from starving.
- Economists argue fiercely
over the causes
of the Great Depression.
Most agree, however,
that a key piece of the puzzle
is an epidemic of bank failures.
This was before deposit insurance.
So if your bank went bankrupt,
your savings disappeared with it.
- [Cashier] Closing your account?
- [Customer] Yes, sir.
I'm closing my account.
I wouldn't leave a nickel
in this bank.
- Faced with a banking crisis,
the Central Bank has a choice:
lend freely to troubled banks
or stand aside and refuse to lend.
Lending freely to banks in trouble
is called "easy money."
Refusing to lend
is called "tight money."
- [Joshua] Monetarist masters
Milton Friedman and Anna Schwartz
famously called
the Great Depression
the "Great Contraction,"
accusing the Federal Reserve
of inflicting a misguided policy
of tight money
on the nation's teetering
financial institutions.
They argued that easy money
would have kept
many banks in business,
shortening the Great Depression.
But others disagree!
If banks are insolvent
because of unwise
lending decisions,
then bailouts just encourage
more foolishness.
Economists called this problem
"moral hazard."
The debate over bailouts
and moral hazard continues today.
Should financial behemoth
Lehman Brothers
had been allowed to fail
on the eve of the Great Recession,
in an ideal world,
we'd answer this question
by applying different Fed policies
to randomly selected regions.
But we can still learn a lot
by using differences-in-differences
to compare trends across areas
with different monetary policies.
- [Camilla] How's that even possible?
Don't the same Fed policies
apply to all banks in the US?
- [Man] Yeah.
- Good question.
The Federal Reserve System
is divided into 12 districts,
each headed by a regional bank.
Today, Fed policy is set
at the national level.
But in the 1930s, regional Feds
could do pretty much as they liked.
- [Man] Ah, interesting.
- And here's what's
so awesome about that.
In 1930, the Atlanta Fed,
running the 6th district,
followed an easy money policy,
sending wheelbarrows of cash
to rescue insolvent institutions.
The St. Louis Fed,
running the 8th district,
followed a tight money policy.
"Let fail the foolish!"
they said in St. Louis.
And so a natural experiment
in monetary policy was born.
Even better, this is
a within-state experiment.
The border between the 6th
and the 8th districts
ran smack through
the middle of Mississippi.
So northern Mississippi
had tight money,
while southern Mississippi
had easy money,
but under the same state laws
and banking regulations in both.
- [Woman] The treatment group
is the district 6th part
of Mississippi,
which had access to easy money
during the crisis.
The control group
is the district 8th part
of Mississippi,
which had tight money
during the crisis.
The key year
in our natural experiment
was 1930.
Caldwell & Company,
a massive financial empire
in the South,
came crashing down.
Banking is a business
built on confidence and trust.
The Caldwell meltdown
caused a panic
that led to a widespread
bank run all at once.
Depositors wanted their money back,
causing banks to go bankrupt
and shut their doors.
We'll use differences-in-differences
to measure the effect
of contrasting monetary policies
in response to the Caldwell crisis.
This figure plots the number
of banks in Mississippi by year,
for the 8th and 6th districts.
Let's start in 1929,
a year before the Caldwell crash.
There are 169 banks
open in the 8th,
and 141 banks open in the 6th.
Over the next year,
we see a similar handful
of banks fail, in both districts.
The change in the number
of banks in operation
is remarkably similar --
that's what parallel trends look like.
In November 1930, Caldwell crashes,
and the panic begins.
Banks failed frequently
in the 8th district,
which had tight money.
But the decline is slower
in the 6th district,
which had easy money.
The diverging trends in this period
might be attributable
to easy versus tight money.
In July of 1931, the 8th district
abandons tight money,
so now both districts are easy.
Parallel trends are restored.
In a counterfactual world,
where the 6th district
follows a tight money policy,
what might have happened?
If we extrapolate the trend
of the 8th district to the 6th,
it would look like this.
So the treatment-effective
easy money
is how much the 6th district
deviated from the path
implied by the 8th district trend.
How many banks
did the easy money treatment save?
This table reports data
for the treatment group, district 6,
in the first row,
and data for the control group,
district 8, in the second row.
The first column shows
the number of banks in business
before the crisis began in 1930.
The second column shows 1931.
This is the key period
when each district
had differing monetary policies
during the crisis.
The rightmost column
reports changes within the district.
District 6 lost 14 banks,
while district 8 lost 33.
The mathematical formula
for the treatment effect is simple.
We subtract the change in banks
in operation in the 8th district
from the change in banks
in operation in the 6th.
Hence, the name
"differences-in-differences."
-14 minus -33 equals 19.
We estimate that 19 banks
were saved by easy money.
In practice, tables and figures
like those shown here
are the beginning
rather than the end
of a DD analysis.
The problem of how to gauge
the statistical significance
of DD estimates
turns out to be exceedingly tricky,
and a regression is typically
part of the solution.
The key assumption
behind a valid DD analysis
is that of parallel trends.
Recall the principle
of ceteris paribus.
Our ideal comparison
would have the two districts
experience an identical
business environment,
except for one factor:
easy or tight money.
Both districts would have
identical types of customers
who would go bankrupt
at exactly the same rate.
The skill of their employees
would be equal, and so on.
Perfect ceteris paribus comparisons
would allow us to clearly see
the causal effect
of different Fed policies.
In this case, that's not possible.
But the idea of parallel trends
is based on a similar concept.
If we see that the two regions
experience similar trends
in the number of banks over time,
in the absence of treatment,
we can assume
they are good comparisons.
We see that the two districts
move in parallel,
both before the crisis and after,
when they have the same Fed policy.
The only time the districts
behave differently
is when the Fed policy is different.
In view of this,
Fed policy is a likely cause
of diverging trends
from 1930 to 1931.
But we should also check
for other changes
unique to northern Mississippi.
- [Man] Huh?
- What do you mean?
- [Woman] Imagine that bad tornadoes
hit northern but not
southern Mississippi in 1930.
These tornadoes devastate farms,
causing farmers
to default on loans,
which drives their banks
out of business.
Then the 6th and 8th districts
would differ in not one
but two ways:
Fed policy and weather.
And we'd have trouble
identifying Fed policy
as the causal factor
behind increased bank failures
in the 8th.
- [Man] Ceteris is not paribus.
- DD credibility lives or dies
with the claim that the only reason
northern Mississippi
was special in 1930
is differing regional Fed policy.
We're in DD heaven with strong,
visual evidence of parallel trend.
- In general, the first step
in evaluating whether to use DD
is usually this type of visual
confirmation of parallel trends
outside of the period,
when we expect to see
a treatment effect.
The treatment in our example
is easy money
in the face of bank failures.
Metrics masters use DD
to explore effects of many policies,
like the minimum legal drinking age,
and environmental changes,
like access to clean water.
In our next video,
we'll see an example
of how regression is used
to implement a DD approach.
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♪ [music] ♪