Red States, Blue States: Two Economies, One Nation

As economists and investors, we treat the United States as one country and one economy and the eurozone as a conglomerate of many countries with a common currency.

There are good reasons for this: The United States is not just a currency union and a single market but also a fiscal union with a uniform legal system.

But the differences among the various US states can be striking. Some time ago, I spoke with a friend about the gulf in living standards between prosperous areas in California or on the East Coast and much poorer sections in the Deep South. Since we had had too much beer, we decided to calculate the gaps in living standards among the various states and correlate them with the results of the presidential election of 2016.

After all, according to the media narrative, it was the forgotten men and women in the Rust Belt and the Midwest who swung the balance in the 2016 presidential election.

The American Human Development Index (AHDI) allows for a state-by-state assessment of critical factors like income, education, and health. When we calculated the average AHDI for the red states — those won by Donald Trump — it was much lower than the average AHDI for blue states. In fact, by way of international comparisons, the blue states won by Hillary Clinton have a human development index similar to the Netherlands, while the red states have an AHDI that resembles Russia's.

Now, before you start writing hate mail or troll me on Twitter, know that I am not making a value judgment here. Red states are neither inferior nor superior to blue states. Both have their very own idiosyncratic challenges.

This is where a recent study by David C. Parsley and Helen Popper comes in. The duo investigated the differences between red and blue states much more thoroughly than my friend and I did over a couple of beers.

So what did they find?

Red and blue states vary so much in their economic trajectories that they may as well be two distinct countries within the United States.

First, blue states have enjoyed higher economic growth rates on average than red states since the Great Recession. Since the mid-2000s, the business cycle of blue states has increasingly diverged from that of their red counterparts.

The average disparity in GDP growth between red states and blue states has hovered around 3.5% since the recession ended. For comparison, a previous study of 20 developed nations found an average GDP convergence among them of only 1.75%.

Differences in GDP growth also lead to differences in household income and household consumption — i.e., in living standards. Luckily, there are several transfer mechanisms that mitigate these gaps in GDP growth so that consumption shortfalls in red states amount to only about one-fifth of the growth deficits.

But Parsley and Popper found that red states and blue states smooth these consumption variations in very different ways.

Capital markets are the most important tool to mitigate consumption gaps from one year to the next and from one state to another. Capital markets ease about 43% of idiosyncratic state risks. In a sense, capital markets render an important service often overlooked in the public debate: They reduce income inequality among the states.

But once capital markets are accounted for, further crucial differences emerge. The second most critical tool to smooth consumption in red states is fiscal transfers. Blue states, on the whole, contribute more tax revenue to federal coffers than they receive in return. So in aggregate, the federal government transfers wealth from the blue states to the red states.

Blue staters, on the other hand, ease the consumption gap by saving more and purchasing durable goods. Of course, poorer households often cannot save and thus must rely on fiscal transfers, so this red state-blue state gap might just be the result of wealth disparities between the two cohorts.

Whatever the cause, the study demonstrates that the current polarization in US politics is misguided and counterproductive. Economically speaking, the red states benefit from the blue states through government redistribution and transfers of capital from blue state savers to red state investments via capital markets.

Blue states benefit from red states, on the other hand, which fuel their higher growth and higher income with attractive investment opportunities as well as cheaper labor and lower prices.

The current political polarization is undermining not only the sense of unity among the American people, but also the future economic growth of the country as a whole.

For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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