- [Teacher] 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.
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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 U.S. 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 U.S.?
- [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.
- [Teacher] The treatment group
is the district 6 part of Mississippi,
which had access to easy money during the crisis.
The control group
is the district 8 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.
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?
- [Teacher] 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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