nber reporter · nber reporterfall 2003 1. ... modern macroeconomics during the past quar- ......

The NBER’s Research Programon Economic Fluctuations and Growthmarks its 25th anniversary this year.During the long U.S. economic expan-sion of the 1990s — the longest in thechronology maintained by the NBER— topics related to growth played alarge role in the Program’s activities.With the onset of a recession in early2001, research on economic fluctua-tions has gained additional attention.

The Business Cycle DatingCommittee

The EFG Program hosts theBusiness Cycle Dating Committeewhich carries out a long-standing func-tion of the NBER, the maintenance ofa chronology of the U.S. business cycle.The Bureau began compiling thechronology in the early 1920s; it nowcovers almost a century and a half ofbusiness-cycle history. I chair the com-mittee, which also includes MartinFeldstein, Jeffrey A. Frankel, Robert J.Gordon, Christina D. Romer, David H.Romer, and Victor Zarnowitz.

On November 26, 2001, the com-mittee announced that a recession hadbegun in the U.S. economy in March2001. That is, a peak in economic activ-

ity occurred during March and theeconomy began to contract. A reces-sion is a significant decline in activityspread across the economy, lastingmore than a few months, visible in realgross domestic product, employment,and other indicators of activity. Thecommittee determined in November2001 that these conditions had been met.

On July 17, 2003, the committee

announced that the recession hadended in November of 2001. Thetrough marked the end of the recessionthat began in March 2001 and thebeginning of an expansion. The reces-sion lasted eight months, which isslightly less than average for recessionssince World War II. Real GDP hasgrown since the trough, as shown in thefigure above.

NBER Reporter Fall 2003 1.

FALL 2003

Economic Fluctuations and Growth

Reporter OnLine at: www.nber.org/reporter

Robert E. Hall*

* Hall is the director of the NBER Program on EconomicFluctuations and Growth and the Robert and CaroleMcNeil Professor of Economics at Stanford University.

Program Report

NATIONAL BUREAU OF ECONOMIC RESEARCH

NBERReporter

0.92

0.94

0.96

0.98

1.00

1.02

1.04

1.06

1.08

2000

:2

2000

:3

2000

:4

2001

:1

2001

:2

2001

:3

2001

:4

2002

:1

2002

:2

2002

:3

2002

:4

2003

:1

2003

:2

2001:4Average prev 6 recessions

Quarterly Real GDPThe dark line shows the movement of quarterly real GDP in 2000-2003 and the shaded line the average over

the previous 6 recessions. Source: Bureau of Economic Analysis, U.S. Department of Commerce(http://www.bea.doc.gov/).

IN THIS ISSUE

Program Report:Economic Fluctuations and Growth 1

Research Summaries:“Capital Account Opening” 9

“Human Creativity” 12Capital Income Taxes 16

NBER Profiles 19Conferences 21

Bureau News 31Bureau Books 36

Current Working Papers 37

Real GDP

2. NBER Reporter Fall 2003

The current recovery has not seen as higha growth rate of real GDP as in the averagerecovery. In addition, productivity has grownunusually rapidly during the recession andrecovery. As a result, employment has contin-ued to decline slightly during the recovery. Indating the trough, the committee relied on thetradition of the Bureau’s business-cycle datingprocedure that emphasized output as themeasure of economic activity, rather thanemployment.

Research Meetings

The EFG Program holds three researchmeetings each year. Each meeting is organizedby a pair of program members, who carry out ahighly competitive selection process to find thesix most suitable papers for the meeting. Theopportunity to be considered is extended to alarge group of potential participants. Almost allof the papers marking significant advances inmodern macroeconomics during the past quar-ter century have appeared at these meetings.

Research Groups

Much of the activity of the EFG pro-gram occurs in its research groups. The groupsmeet during the NBER’s Summer Institute inJuly in Cambridge and occasionally at othertimes and locations as well.

Economic Growth — Charles I.Jones and Peter J. Klenow, Leaders

This group conducts research on a rangeof subjects related to long-run economic per-formance. Its meetings focus on such topics asdifferences in income across countries, firm-level productivity growth, and technicalprogress over time, as illustrated by the follow-ing papers:

Based on a study of immigrants, LutzHendricks1 presents new evidence on thesources of cross-country income differences.His estimates suggest that, for countries whoseoutput per worker is below 40 percent of U.S.output per worker, less than half of that rela-tive output gap can be attributed to human andphysical capital.

Simon Djankov, Rafael La Porta,Florencio Lopez de Silanes, and AndreiShleifer2 present new data on the regulation ofentry of start-up firms in 85 countries contain-ing information on the number of procedures,official time, and official cost that a start-upmust bear before it can operate legally. Theofficial costs of entry are high in most coun-

The National Bureau of Economic Research is a private, nonprofit researchorganization founded in 1920 and devoted to objective quantitative analysis ofthe American economy. Its officers and board of directors are:

President and Chief Executive Officer — Martin FeldsteinVice President for Administration and Budget — Susan ColliganController — Kelly Horak

BOARD OF DIRECTORS

Chairman — Michael H. MoskowVice Chairman — Elizabeth E. BaileyTreasurer — Robert Mednick

DIRECTORS AT LARGE

DIRECTORS BY UNIVERSITY APPOINTMENT

DIRECTORS BY APPOINTMENT OF OTHER ORGANIZATIONS

Richard B. Berner, National Association for Business EconomicsGail Fosler, The Conference BoardA. Ronald Gallant, American Statistical AssociationRichard C. Green, American Finance AssociationThea Lee, American Federation of Labor and Congress of

Industrial OrganizationsRobert Mednick, American Institute of Certified Public AccountantsAngelo Melino, Canadian Economics AssociationJeffrey M. Perloff, American Agricultural Economics AssociationJohn J. Siegfried, American Economic AssociationJosh S. Weston, Committee for Economic DevelopmentGavin Wright, Economic History Association

The NBER depends on funding from individuals, corporations, and privatefoundations to maintain its independence and its flexibility in choosing itsresearch activities. Inquiries concerning contributions may be addressed toMartin Feldstein, President & CEO, NBER 1050 Massachusetts Avenue,Cambridge, MA 02138-5398. All contributions to the NBER are taxdeductible.

The Reporter is issued for informational purposes and has not been reviewed bythe Board of Directors of the NBER. It is not copyrighted and can be freelyreproduced with appropriate attribution of source. Please provide the NBER’sPublic Information Department with copies of anything reproduced.

Preparation of the NBER Reporter is under the editorial supervision of DonnaZerwitz.

Requests for subscriptions, changes of address, and cancellations should besent to Reporter, National Bureau of Economic Research, Inc., 1050Massachusetts Avenue, Cambridge, MA 02138-5398. Please include the cur-rent mailing label.

NATIONAL BUREAU OF ECONOMIC RESEARCH

NBERReporter

Peter AldrichElizabeth E. BaileyJohn Herron BiggsAndrew BrimmerJohn S. ClarkesonDon R. ConlanGeorge EadsJessica P. Einhorn

Martin FeldsteinJacob A. FrenkelJudith M. GueronRobert S. HamadaGeorge HatsopoulosKaren N. HornJudy C. LewentJohn Lipsky

Laurence H. MeyerMichael H. MoskowAlicia MunnellRudolph A. OswaldRobert T. ParryRichard N. RosettMarina V. N. WhitmanMartin B. Zimmerman

George Akerlof, California, BerkeleyJagdish W. Bhagwati, Columbia Michael J. Brennan, California, Los Angeles Glen G. Cain, WisconsinRay C. Fair, YaleFranklin Fisher, MITSaul H. Hymans, MichiganMarjorie B. McElroy, Duke

Joel Mokyr, NorthwesternAndrew Postlewaite, PennsylvaniaUwe Reinhardt, PrincetonNathan Rosenberg, StanfordCraig Swan, MinnesotaDavid B. Yoffie, HarvardArnold Zellner, Chicago


tries, and could explain a portion ofthe sizable income differences acrosscountries.

Daron Acemoglu, SimonJohnson, and James Robinson3 studythe interplay between growth and insti-tutions. They show that the rise ofEurope between 1500 and 1850 wasdriven primarily by cities along theAtlantic coast, especially by thoseengaged in colonialism and long-dis-tance oceanic trade. The economicbenefits from this trade strengthenedthe commercial class, leading toimprovements in property rights andinstitutions that furthered WesternEuropean growth and the emergenceof the modern world.

One widely held view is that com-petitive pressure can boost firm pro-ductivity, but the evidence to supportthis view is not plentiful. Jose Galdon-Sanchez and James Schmitz4 thereforestudy the U.S. and Canadian iron-oreindustries in the early 1980s. They findthat an increase in domestic and inter-national competition did lead to largegains in labor productivity at continu-ing mines producing the same productswith the same technology. Tor JakobKlette and Samuel Kortum5 also studyfirm productivity, but they emphasizeR and D rather than competition. Theirresearch explains why R and D as afraction of revenues is related stronglyto firm productivity yet largely unrelat-ed to firm size or growth.

Rodolfo Manuelli and AnanthSeshadri6 study the lag between theintroduction of technology and itsadoption. According to the conven-tional wisdom, slow technology diffu-sion suggests some sort of friction, forexample vintage physical capital, vin-tage human capital, or local informa-tional externalities. Their work, basedon the diffusion of tractors in theUnited States between 1910 and 1960,shows otherwise.

Consumption — OrazioAttanasio, Christopher D.Carroll, and Jose Victor Rios-Rull, Leaders

This research ranges from purelyempirical studies using microeconomicdata to purely theoretical analyses of

dynamic stochastic general equilibriummodels with uninsurable idiosyncraticrisk.

Nicholas Souleles and his co-authors7 use microeconomic data toshow that the timing of a household’sreceipt of a tax rebate check has a verystrong effect on the timing of house-hold spending, contrary to the predic-tions of standard consumption theory.

Jonathan Heathcote, KjetilStoresletten, and Gianluca Violante8

explore the macroeconomic and wel-fare implications of the sharp rise inU.S. wage inequality over the last sev-eral decades. They show that if a sub-stantial component of the increasedwage variation is transitory but persist-ent, a standard optimizing model canreconcile the widening income distri-bution with a stable distribution ofconsumption across families.

Over the last few years severalpapers have examined why householdsin the uppermost part of the perma-nent income distribution save so muchmore than the typical household.Among the potential explanationsexplored have been: imperfect capitalmarkets that require business venturesto be self-financed9,10; the risk of med-ical expenses that will not be coveredby insurance11; and preferences thatembody habit formation rather thanthe usual intertemporal separability12.

Another persistent recent threadhas been the importance of spendingon durable goods. Brian Peterson13

develops a theoretical model that gen-erates strong cyclicality of spending onhousing via an interaction betweencyclical variations in uncertainty andthe effect of uncertainty on spendingwhen there are durable goods thatcan’t be resold. Burcu Duygan14 pres-ents complementary microeconomicempirical work, showing that, control-ling for the fall in income during the1994 Turkish financial crisis, thoseconsumers whose unemployment riskincreased more cut their spending ondurable goods by more. In previousyears, Antonia Diaz and María JoséLuengo-Prado15 argued that under-standing the dynamics of durablegoods ownership can substantiallymodify the interpretation of wealthinequality in microeconomic data.Also, Dirk Krueger and Jesus

Fernandez-Villaverde16 suggested thatwhen the concentration of durablegoods expenditures in the early yearsof the life cycle is taken into account,life-cycle patterns of total consump-tion of services are less steeply slopedthan appears when only spending onnondurables and services are consid-ered together.

Income Distribution andMacroeconomics — RolandBenabou, Steven N. Durlauf,and Oded Galor, Leaders

The marked rise in inequality inmost developed countries over thepast 20 years again has broughtincome distribution to the forefront ofeconomists’ and policymakers’ con-cerns. NBER researchers haveexplored a wide range of issues relatedto the sources and consequences ofinequality at both the national andinternational levels. This researchgroup is notable for its combination ofempiricists, theorists, and econometri-cians. The interactions across theirresearch orientations have led to valu-able cross-fertilization in individualresearch programs and to generalprogress on the broad issues that lie atthe core of the group’s interests.

The group devoted significantattention to three fundamentalresearch avenues: 1) the identificationof channels through which the distri-butions of income, human capital, andfinancial assets affect aggregate per-formance in the medium and long run,within and across countries; 2) thedeterminants of inequality itself, interms of both exogenous shocks andsources of persistence; and 3) the roleof political institutions and social con-flict in the determination of cross-country growth differences, includingthe use of history in understandingcontemporaneous economic issues.

For instance, Dilip Mookherjeeand Debraj Ray17 focus on credit mar-ket frictions and related principal-agent contractual imperfections. Theauthors identify general conditionsunder which poverty traps, resulting inpersistent inequality and suboptimaloutput, can appear. On the empiricalside, the often-nonlinear implications


of credit-constraint models for therelationship between inequality andgrowth have motivated research byAbhijit Banerjee and Esther Duflo.18

They critically re-examine previouseconometric studies of this relation-ship, particularly those using paneldata. Francesco Casselli and NicolaGennaioli19 present a model of occu-pational choice with contractualimperfections. It attributes a signifi-cant fraction of the income gapbetween less developed, countries(LDCs) and advanced countries to amisallocation of talents, taking theform of a much higher share of fami-ly-owned firms in LDCs.

Mathias Thoenig and ThierryVerdier20 present a model of how firmsin developed countries respond tocompetition from low-wage countrieswith defensive skill-biased technologi-cal innovations that further exacerbatewage inequality. Michael Kremer andEric Maskin21 show how internationaltrade and outsourcing lead to arematching of workers of differentskill levels across countries into differ-ent production structures or teams,thus explaining the simultaneous risein earnings inequality in both thedeveloped and the developing world.Taking a longer, historical perspective,Oded Galor and Andrew Mountford22

show how the emergence of interna-tional trade in the nineteenth century,leading countries like India to special-ize away from skill-intensive goods,delayed these countries’ demographictransition by skewing fertility choicestowards quantity rather than “quality”of children, and how this causes diver-gent growth performances.

There also has been work onsocial interactions and the macroeco-nomic implications of sorting, includ-ing a paper by Raquel Fernandez,Nazih Guner, and John Knowles,23thatpresents a model of marital sortingamong men and women with differenteducation levels. William Brock andSteven N. Durlauf24 develop methodsfor studying neighborhood and peereffects. Among the empirical studiesare a paper by William Easterly25 on thedynamics of racial segregation in U.S.cities, and one by Jeffrey B. Liebman,Jeffrey R. Kling, and Lawrence F.Katz26 on studying the effects of the

Moving to Opportunity housingvoucher program on the educationaland labor market outcomes of chil-dren and adults in poor households.

On the political-economy side ofmacroeconomics work, the workincludes a paper by Olivier J.Blanchard and Francesco Giavazzi27

that examines how deregulation ingoods and labor markets will affectunemployment and wage dynamics, inparticular explaining recent move-ments in the labor share. Togetherwith Thomas Philippon, Blanchard28

also presents a study of how the dis-mantling of barriers to entry and capi-tal mobility has eroded rents, with apositive effect on efficiency in the longrun, but a possible adverse effect in themedium run in countries where learn-ing by unions is slowest. Gilles-SaintPaul29 develops a model of job creationand job destruction in a growingeconomy with embodied technicalprogress, and uses it to analyze thepolitical support for employment pro-tection legislations.

Another important line ofinquiry — by John Hassler, JoseRodriguez Mora, Kjetil Storesletten,and Fabrizio Zilibotti30 — is why thewelfare state is so different in Europecompared to the United States.Alberto Alesina and Eliana LaFerrara31

use individual data to show how a per-son’s support for redistributive policiesis affected negatively by her perceivedlikelihood of moving up in the incomedistribution and by the extent to whichshe believes that American societyoffers equal opportunities to all.

The role of institutions in pro-moting or hindering growth has alsobeen studied theoretically and empiri-cally from a historical perspective.Daron Acemoglu, Simon Johnson, andJames Robinson32 provide evidencethat among countries colonized byEuropean powers, those that were rel-atively rich in 1500 are now relativelypoor. They argue that this reversal offortune reflects the introduction ofinstitutions encouraging investment inregions that were previously poor.Oded Galor, Omer Moav, and DietrichVollrath33 present a theory of thedevelopment process in which com-plementarity between human andphysical capital leads powerful land-

lords to switch from opposing publiceducation to supporting it.

Forecasting and EmpiricalMethods inMacroeconomics andFinance — Mark W.Watson and Kenneth D.West, Leaders

This group focuses on the devel-opment and assessment of economet-ric methods for use in empiricalmacroeconomics and finance, placingspecial emphasis on problems of pre-diction. It meets jointly with a groupon forecasting, under the Committeeon Econometrics and MathematicalEconomics umbrella, with supportfrom the National Science Foundation.

Recent meetings have discussed:methods and applications of factormodels for macroeconomic forecast-ing and structural analysis; nonlinearforecasting models and methods;inference issues in models with persist-ent regressors; evaluating models usingout-of-sample predictive accuracytests; instrumental variable and GMMmethods; and empirical asset pricing.

These papers use panel datasetswith large cross-section and timedimensions. Ben Bernanke, Jean Boivin,and Piotr Eliasz34 and DomenicoGiannone, Lucrezia Reichlin, and LucaSala35 use factor models to study mone-tary policy in the United States.Policymakers at the Federal Reserveset interest rates after studying hun-dreds or even thousands of time seriesfor clues about the current and futurebehavior of inflation and real activity.This means that the small vectorautoregressions often used to studymonetary policy may suffer fromimportant omitted variables bias andthus yield misleading results aboutmonetary policy.

The usual VAR methods cannotbe used when the number of timeseries is large because the number ofparameters in the VAR is proportionalto the square of the number of series.Factor models can solve this problem.In these models, latent or unobservedfactors are used to explain the co-movement of a set of time series.These factors can be used to summa-

rize the information in a large numberof time series. The empirical analysisin the two papers just described iscomplementary. The first studies theeffects of monetary policy shocks, andthe second studies technology andaggregate demand shocks. The resultssuggest that during the Greenspan era,the Federal Reserve has raised interestrates in response to aggregate demandshocks, but has changed rates far lessin response to technology shocks.

Jushan Bai36 provides some impor-tant statistical foundations for the useof principal components. He showsthat when the cross section is suffi-ciently large, the sampling error in theestimated factors can be ignored whencarrying out many of the usual kindsof statistical inference, such as con-structing confidence intervals for fore-casts or standard errors on VARimpulse responses. Bai’s work alongwith the work of others in this groupset the stage for a much broader use ofstructural factor models in macro-econometrics.

The Labor Market inMacroeconomics —Richard Rogerson, RobertShimer, and Randall Wright,Leaders

The labor market is central tomany issues in macroeconomics,including business cycles, unemploy-ment, inequality, and growth. Thisgroup’s research ranges from founda-tional work on model building, toquantitative evaluation of models, sub-stantive policy evaluation, and datadescription.

The idea that trading frictionsplay an important role in shapingaggregate labor market outcomes hasbecome increasingly standard over thepast years. The early work of Peter A.Diamond, Dale Mortensen, andChristoper Pissarides has spawned aclass of models that have become thestandard in formalizing these tradingfrictions. Many of the papers present-ed in this group add to this overallresearch effort, albeit along very differ-ent dimensions.

In the context of these models,

frictions can help us to understandwhy the steady state unemploymentrate is as high as it is in a country likethe United States. But another keyissue is to what extent these frictionshelp us to understand cyclical fluctua-tions in unemployment. RobertShimer37 argues that in the standardmatching model the frictions canaccount for only a small fraction ofcyclical fluctuations in the labor mar-ket. An important driving force behindthis result is that the standard modelassumes that wages are determined byNash bargaining, which in turn impliesthat wages increase during good timesand thus seriously dampen the incen-tives of firms to create new jobs. In amore recent paper, I38 build on theseinsights by showing that a particularformulation of wage setting is consis-tent with both no unrealized bilateralgains to trade and wages that are rela-tively unresponsive to shocks to thevalue of a match. As a result, I providean internally consistent model of labormarket fluctuations that can replicatethe main stylized facts.

I show too that matching modelshave a large set of equilibrium wagesthat are consistent with no unrealizedbilateral gains to trade. In that setting,empirical understanding of wagedetermination is central. Mortensen39

uses matched worker-firm data fromDenmark to compare Nash bargainingto unilateral wage-setting by workers,with employment then determined bythe firm. He finds that the Nash bar-gaining mechanism does a better jobof matching the data.

One issue that has seen ongoingattention in this group is the effect oflabor market institutions on labor mar-ket outcomes. The topics coveredinclude: the implications of fixed-termlabor contracts in the European con-text; the short-run effects of labormarket flexibilization in Argentina; therole of taxes on labor market out-comes in Europe compared to theUnited States; the effects of firingcosts and wage compression on unem-ployment durations; and the effect oflabor market regulations on measuredproductivity.

Empirical work on labor marketdynamics stresses the large magnitudeof labor market flows. Many of these

flows consist of workers making job-to-job transitions. Gadi Barlevy40

demonstrates that the reallocation ofworkers to better matches associatedwith the job-to-job flows is reduced inrecessions. This effect opposes thecleansing effect of recessions that hasbeen widely cited. Ken Burdett,Ryoichi Imai, and Randall Wright41

show that a model with on-the-jobsearch (and hence job-to-job transi-tions) will lead quite naturally to multi-ple equilibriums that can be ranked interms of the overall level of turnover.

Capital Markets and theEconomy — Janice C.Eberly and Deborah J. Lucas,Leaders

This group brings togetherresearchers working on capital marketsfrom a variety of perspectives, includ-ing corporate finance, asset pricing,macro and monetary economics, inter-national economics, and consump-tion/investment. Their common goalis a better understanding of the deter-minants and interactions of real andfinancial investments, and their effecton individual welfare and the macro-economy. Recent work in this groupcenters on the effect of regulation onreal investment; determinants of indi-vidual portfolio choice; the impact offinancing constraints and irreversibilityon firm-level investment; and the roleof institutions, information, andbeliefs in financial markets.

Alberto Alesina, Silvia Ardagna,Giuseppe Nicoletti, and FabioSchiantarelli42 find that various meas-ures of regulation are negatively relat-ed to investment in physical capital.The authors use a new dataset onproduct market regulation of commu-nications, utilities, and transportationin a set of OECD countries. Theirresults indicate that entry barriers havea particularly strong negative effect onnew investment.

Simon Gilchrist and MarcRysman43 develop and study a newdataset on Chilean manufacturingplants to estimate a model of discreteinvestment useful for policy analysis.Joao Gomes, Amir Yaron, and LuZhang44 specify and estimate a model


of investment with adjustment costsand costly external financing. Usingboth aggregate measures, such as thedefault premium, and firm-specificmeasures, such as leverage, they findno significant role for a financing pre-mium in investment returns.

Andrea Caggese45 studies thebehavior in industry equilibrium offirms facing both a borrowing con-straint and a non-negativity constrainton investment. His results suggest thatthe two constraints are mutually rein-forcing, even though the financingconstraint binds when the firm isgrowing, while the irreversibility con-straint binds when the firm would pre-fer to shrink. The second constraintamplifies the effect of either alone,and leads to inventory behavior consis-tent with what is found empirically.

Stephen Bond’s paper on physicalinvestment46 takes a more theoreticalperspective on such investment andfinancing constraints, examining itssensitivity to cash flow. He analyzesthe effect of cash flow on investmentwhen a control for fundamentals isincluded in an investment regression.His results indicate that firms with agreater sensitivity of investment tocash flow will have a larger externalfinancing premium. Thus, in thissense, cash flow sensitivity can beinterpreted as a measure of the severi-ty of financing constraints.

Turning to the role of financialinstitutions in credit markets, JosephPeek and Eric S. Rosengren47 use firm-and bank-level evidence from Japan toexamine the allocation of credit in theJapanese banking system. Their resultssuggest that additional credit is chan-neled to firms in poor financial condi-tion, and that these firms continue toperform poorly even after the exten-sion of credit. Refet Gurkaynak48con-siders whether the capital structure ofbank intermediaries can exacerbateeconomic shocks through a creditchannel.

Two papers address aspects ofportfolio choice. Francisco Gomes,Alexander Michaelides, and ValeryPolkovnichenko49 look at the optimalallocation of tax-deductible assetsbetween tax sheltered and non-shel-tered accounts, in a calibrated life-cyclemodel with labor income shocks. The

model implies segregation of assetsbearing high tax rates in tax deferredaccounts. Many investors appear tocontradict this advice, holding taxableinvestments such as dividend payingstocks and bonds outside of shelteredaccounts. Entrepreneurs make finan-cial investment decisions that interactwith their ability to invest in entrepre-neurial activity. Hugo Hopenhayn andGalina Vereshchagina50 show that capi-tal constraints can induce risk-prefer-ring behavior by entrepreneurs, espe-cially early in their careers. This mighthelp to explain the apparently highrisk-to-reward ratio many entrepre-neurs seem to choose.

Understanding the relationshipbetween financial market prices andfundamental value is the topic of thefinal two papers. I51 derive the relation-ship between earnings and prices in amodel with adjustment costs. RobertChirinko and Huntley Schaller52 findsome evidence that financial marketvaluations overly influence the level ofreal investments, by looking at the suc-cess of future investments as a func-tion of past financial returns.

Impulses and PropagationMechanisms — Martin S.Eichenbaum and Lawrence J.Christiano, Leaders

This group considers two keyissues: 1) what are the major sources offluctuations in economic activity? and2) what are the key mechanisms bywhich these shocks are propagatedacross sectors of the economy, overcountries and over time? In exploringthese questions, group members focuson three related activities: empiricallyidentifying the effects of exogenousshocks on the economy; constructingempirical general equilibrium modelsof economic fluctuations; and explor-ing the efficacy of alternative policyresponses to different shocks.

Jordi Gali, David Lopez-Salido,and Javier Valles;53 Lawrence Christiano,Martin Eichenbaum, and RobertVigfusson;54 and David Altig, Christiano,Eichenbaum, and Jesper Linde55 allwork on isolating the effects of tech-nology shocks on the U.S. economy.The key issues here are: how we can

reliably identify aggregate technologyshocks to the economy, including theireffects on key macro variables likeemployment, and what role has mone-tary policy played in the transmissionof these shocks? The previous papersargue that technology shocks generateexpansions in employment. But thereason the U.S. economy responds totechnology shocks the way it does hasto do with monetary policy. The mod-els developed in these papers suggestthat if the Fed had not been accom-modative in response to a positivetechnology shock, employment initial-ly would have fallen rather thanexpanded in the wake of technologyshocks.

Other members of this groupfocus on measuring the effects of fis-cal shocks. For example, CraigBurnside, Eichenbaum, and JonasFisher56 investigate the response ofhours worked and real wages tochanges in military purchases. A mili-tary shock causes a persistent increasein government purchases and a rise intax rates, plus a persistent rise inaggregate hours worked and a declinein real wages. Susantu Basu and MilesKimball57 argue that models embody-ing nominal rigidities provide a moreconvincing account of this evidence.Using different identifying assump-tions, Gali, Lopez-Salido, and Valles58

show that shocks to government pur-chases do not lead to expansions inaggregate employment and output butto a rise in real wages. This leads themto explore non-neoclassical mecha-nisms to account for the effects ofshocks to government purchases.

Christiano, Eichenbaum, andCharles Evans59 construct and estimatea dynamic general equilibrium modelembodying nominal wage rigidities aswell as frictions to the real side of theeconomy. Michelle Alexopoulos60

argues that efficiency wages and seg-mented financial markets play a keyrole in the monetary transmissionmechanism. Consistent with thisemphasis on labor market frictions,Gali, Mark Gertler, and Lopez-Salido61

develop a theory-based measure of thevariations in aggregate economic effi-ciency associated with business fluctu-ations. They decompose this indicator,which they refer to as “the gap,” into


two constituent parts: a price markupand a wage markup. They show thatthe latter accounts for the bulk of thefluctuations in their gap measure.

Jess Benhabib, Stephanie Schmitt-Grohe, and Martin Uribe62 explore thenature of optimal monetary policyonce the zero bound on nominal inter-est rates is taken into account. Theyargue that Taylor-type interest-ratefeedback rules give rise to unintendedself-fulfilling decelerating inflationpaths and aggregate fluctuations driv-en by arbitrary revisions in expecta-tions. They then propose several fiscaland monetary policies that preservethe appealing features of Taylor rules,such as local uniqueness of equilibri-um near the inflation target, and at thesame time rule out the deflationaryexpectations that can lead an economyinto a liquidity trap. Finally, GautiEggertsson and Michael Woodford63

study optimal monetary policy in aNew Keynesian model when real dis-turbances cause the natural interestrate to be temporarily negative.

1 L. Hendricks, “How Important is HumanCapital for Development? Evidence fromImmigrant Earnings,” American Eco-nomic Review, 92 (March 2002), pp.198-219.2 S. Djankov, R. La Porta, F. Lopez deSilanes, and A. Shleifer, “The Regulation ofEntry,” NBER Working Paper No. 7892,September 2000, and Quarterly Journalof Economics, 117 (February 2002), pp.1-37.3 D. Acemoglu, S. Johnson, and J. Robinson,“The Rise of Europe: Atlantic Trade,Institutional Change and EconomicGrowth,” NBER Working Paper No.9378, December 2002.4 J. Galdon-Sanchez and J. Schmitz,“Competitive Pressure and LaborProductivity: World Iron-Ore Markets in the1980s,” American Economic Review,92 (September 2002), pp. 1222-35.5 T. Klette and S. Kortum, “InnovatingFirms and Aggregate Innovation,” NBERWorking Paper No. 8819, February 2002.6 R. Manuelli and A. Seshadri, “FrictionlessTechnology Diffusion: The Case ofTractors,” NBER Working Paper No.9604, April 2003.7 N. Souleles, S. Agarwal, C. Liu, D.Johnson, and J. Parker, “The Response ofConsumer Spending and Debt to Tax

Rebates: Evidence from the CEX and theHousehold Credit Accounts,” manuscript,2003.8 J. Heathcote, K. Storesletten, and G.Violante, “The Macroeconomic Implicationsof Rising Wage Inequality in the U.S.,”manuscript, 2003.9 V. Quadrini, “Uninsurable InvestmentRisks,” manuscript, 2003.10 V. Quadrini and M. Mrkaic,“Entrepreneurial Investment and Savings,”manuscript, 2001.11 E. French and J. Jones, “On theDistribution and Dynamics of Health CareCosts,” manuscript, 2003.12 A. Michaelides, “Buffer Stock Saving andHabit Formation,” manuscript, 2003.13 B. Peterson, “Aggregate Uncertainty,Individual Uncertainty, and the HousingMarket,” manuscript, 2003.14 B. Duygan, “Analyzing Durable GoodsPurchases and Idiosyncratic IncomeUncertainty,” manuscript, 2003.15 A. Diaz and M. Luengo-Prado,“Precautionary Savings and WealthDistribution with Durable Goods,” manu-script, 2003.16 D. Krueger and J. Fernandez-Villaverde,“Consumption over the Life Cycle: Facts fromConsumer Expenditure Survey Data,”NBER Working Paper No. 9382,December 2002.17 D. Mookherjee and D. Ray, “PersistentInequality,” Review of EconomicStudies, 70 (April 2003), pp. 369-93.18 A. Banerjee and E. Duflo “Inequality andGrowth: What can the Data Say?” Journalof Economic Growth, 8 (September2003).19 F. Caselli and N. Gennaioli, “DynasticManagement,” NBER Working Paper No.9442, January 2003. 20 M. Thoenig and T. Verdier, “A Theory ofDefensive Skill-Biased Innovation andGlobalization, American EconomicReview, 93 (June 2003), pp. 709-28.21 M. Kremer and E. Maskin,“Globalization and Inequality,” HarvardUniversity manuscript, 2003. 22 O. Galor and A. Mountford, “Trade,Demographic Transition, and the GreatDivergence,” Brown University manuscript,2003. 23 R. Fernandez, N. Guner, and J. Knowles,“Inequality, Education, and MaritalSorting,” NBER Working Paper No.8580, November 2001.24 W. Brock and S. Durlauf, “MultinomialChoice with Social Interactions,” NBER

Technical Working Paper No. 288, March2003.25 W. Easterly, “The Racial Tipping Point inAmerican Neighborhoods: UnstableEquilibrium or Urban Legend,” New YorkUniversity manuscript, 2003.26 J.B. Liebman, J. R. Kling, and L.F. Katz,“What Randomized Experiments CanTeach Us About Social Interactions,”Harvard University manuscript, 2003. 27 O. J. Blanchard and F. Giavazzi,“Macroeconomic Effects of Regulation andDeregulation in Goods and Labor Markets”Quarterly Journal of Economics, 118(August 2003). 28 O. J. Blanchard and T. Philippon, “TheDecline of Rents”, MIT manuscript, 2002.29 G. Saint-Paul, “The Political Economy ofEmployment Protection,” Journal ofPolitical Economy, 110 (June 2002), pp.672-701. 30 J. Hassler, J. Rodriguez Mora, K.Storesletten, and F. Zilibotti, “The Survivalof the Welfare State,” AmericanEconomic Review, 93 (March 2003), pp.87-112. 31 A. Alesina and E. LaFerrara,“Preferences for Redistribution in the Land ofOpportunities,” NBER Working Paper No.8267, May 2001. 32 D. Acemoglu, S. Johnson, and J. Robinson,“Reversal of Fortune: Long-Run Changes inthe Distribution of Prosperity,” QuarterlyJournal of Economics, 117 (November2002), pp. 1231-94. 33 O. Galor, O. Moav, and D. Vollrath,“Land Inequality and the Origin ofDivergence and Overtaking in the GrowthProcess: Theory and Evidence,” BrownUniversity manuscript, 2002. 34 B. Bernanke, J. Boivin, and P. Eliasz,“Measuring the Effects of Monetary Policy:A Factor-Augmented Vector Auto-Regressive (FAVAR) Approach,” manu-script, 2003.35 D. Giannone, L. Reichlin, and L. Sala,“Tracking Greenspan: Systematic andUnsystematic Monetary Policy Revisited,”CEPR Discussion Paper 3550, 2002.36 J. Bai, “Inferential Theory for FactorModels of Large Dimensions,” manuscript,2002.37 R. Shimer, “The Cyclical Behavior ofEquilibrium Unemployment and Vacancies:Evidence and Theory,” NBER WorkingPaper No. 9536, March 2003.38 R.E. Hall, “Wage Determination andEmployment Fluctuations,” manuscript,2003.


39 D. Mortensen, “How Are (Danish) WagesDetermined?” manuscript, 2003. 40 G. Barlevy, “The Sullying Effects ofRecessions,” Review of EconomicStudies, (January 2002), pp. 65-96.41 K. Burdett, R. Imai, and R. Wright,“Unstable Relationships,” PIER WorkingPaper No. 02-037, 2002.42 A. Alesina, S. Ardagna, G. Nicoletti,and F. Schiantarelli, “Regulation andInvestment,” NBER Working Paper No.9560, March 2003.43 S. Gilchrist and M. Rysman, “TradeLiberalization and Lumpy Investment:Evidence from Chilean Plant-level Data,”manuscript, 2003. 44 J. Gomes, A. Yaron, and L. Zhang,“Investment and Returns with FinancingConstraints: Evidence Using Firm Data,”manuscript, 2003.45 A. Caggese, “Financing Constraints,Irreversibility, and Investment Dynamics,”manuscript, 2003.46 S. Bond, “Conditional Cash FlowSensitivities and Financing Constraints,”manuscript, 2003. 47 J. Peek and E.S. Rosengren, “UnnaturalSelection: Perverse Incentives and theMisallocation of Credit in Japan,” NBER

Working Paper No. 9643, April 2003.48 R. Gurkaynak, “Financial Intermediariesas Firms and the Business Cycle,” manu-script, 2003.49 F. Gomes, A. Michaelides, and V.Polkovnichenko, “Life Cycle Portfolio Choicewith Taxable and Tax Deferred Accounts,”manuscript, 2003.50 H. Hopenhayn and G. Vereshchagina,“Risk Taking by Entrepreneurs,” manu-script, 2003.51 R.E. Hall, “The Dynamics of CorporateEarnings,” manuscript, 2003.52 R. Chirinko and H. Schaller, “Glamour vs.Value: The Real Story,” manuscript, 2003.53 J. Gali, J. Lopez-Salido, and J. Valles,“Technology Shocks and Monetary Policy:Assessing the Fed’s Performance,” NBERWorking Paper No. 8768, February 2002.54 L.J. Christiano, M.S. Eichenbaum, andR. Vigfusson, “What Happens after aTechnology Shock,” NBER Working PaperNo. 9819, July 2003.55 D. Altig , L.J. Christiano, M.S.Eichenbaum, and J. Linde, “TechnologyShocks and Aggregate Fluctuations,” manu-script, 2003.56 C. Burnside, M.S. Eichenbaum, and J.Fisher, “Fiscal Shocks and Their

Consequences,” NBER Working Paper No.9772, June 2003.57 S. Basu and M. Kimball, “InvestmentPlanning Costs and the Effects of Fiscal andMonetary Policy,” manuscript, 2003.58 J. Gali, D. Lopez-Salido, and J. Valles,“Technology Shocks and Monetary Policy:Assessing the Fed’s Performance,” NBERWorking Paper No. 8768, February 2002.59 L.J. Christiano, M.S. Eichenbaum, andC. Evans, “Nominal Rigidities and theDynamic Effects of a Shock to MonetaryPolicy,” NBER Working Paper No. 8403,July 2001. 60 M. Alexopoulos, “Efficiency Wages andInter-Industry Wage Differentials,” manu-script, 2002. 61 J. Gali, M. Gertler, and D. Lopez-Salido,“Markups, Gaps, and the Welfare Costs ofBusiness Fluctuations,” NBER WorkingPaper No. 8850, March 2002. 62 J. Benhabib, S. Schmitt-Grohe, and M.Uribe, “Backward-Looking Interest-RateRules, Interest-Rate Smoothing, andMacroeconomic Instability,” NBERWorking Paper No. 9558, March 2003. 63 G. Eggertsson and M. Woodford, “TheZero Bound on Interest Rates and OptimalMonetary Policy,” manuscript, 2002.


*


One salient feature of the globaleconomy over the last 20 years hasbeen the embrace by developing coun-tries of financial reforms, leading togrowing opening of capital accounts.The adjustment process to financialintegration has been rocky: growingfinancial opening frequently has beenassociated with financial crises.Literature on the subject has led to aspirited debate concerning the wisdomof unrestricted capital mobilitybetween the OECD and emergingmarkets.1 Notwithstanding this debate,the strongest argument for financialopening may be a pragmatic one. Likeit or not, greater trade integrationerodes the effectiveness of restrictionson capital mobility. Hence, for success-ful emerging markets that engage intrade integration, financial opening isnot a question of if, but rather ofwhen and how. Consequently, thepragmatic approach to the problemshould recognize that there is no quickfix to exposure to financial crisesinduced by financial opening. Instead,the challenge is to reduce the depthand frequency of the crises. Thisreport reviews some of my recentresearch on these issues.

Limited Access toInternational FinancialMarkets and thePrecautionary Demand forInternational Reserves byDeveloping Countries

One frequent by-product offinancial opening has been financialcrises. A possible mechanism thatexplains these crises is the inflow ofshort-term capital in the aftermath offinancial opening (inflows dubbed as“hot money”). These short-term flowsare “footloose,” subject to abruptreversal, exposing the developingcountry to greater hazard of a liquiditysqueeze, occasionally leading to full-blown financial crises. Nancy Marionand I show that hoarding foreignexchange reserves may serve a usefulrole in dealing with exposure to suchcrises.2 These findings are consistentwith the observation that since the1997-8 Asian financial crises, monetaryauthorities in emerging markets in EastAsia have more than doubled theirstockpiles of foreign exchangereserves.

Marion and I start by conductingstatistical analyses to explain the hold-ings of international reserves by devel-oping countries, using the convention-al variables employed in the literature.We extend these analyses by addingtwo political measures that may lowerthe demand for reserves. We confirmthat an increase in an index of politicalcorruption significantly reduces

reserve holdings, as does an increase inthe probability of a change in govern-ment leadership. Our research leads usto conclude that the recent largebuildup of international reserve hold-ings in East Asia is motivated by theexperience of the recent Asian finan-cial crisis.3 Therefore, we examine thepossibility that the buildup may repre-sent “precautionary” holdings, andfind two situations that can give rise toincreased demand for such holdings.4

The first is the government’sdesire to “smooth consumption”—that is, to spread over time the costs ofshocks. When countries’ access to cap-ital markets is diminished, and when itis costly to either raise taxes or cut gov-ernment spending, then countries willfind it desirable to hold large precau-tionary reserve balances. The modelalso helps us to understand why somedeveloping countries have chosen notto hold large precautionary reserve bal-ances. Specifically, countries thatstrongly favor current consumption,that experience political instability, orthat suffer from political corruptionface a lower effective return on hold-ing reserves and will accumulate moremodest stockpiles.

The second situation leading to abuildup of reserves is “loss aversion”after the 1997-8 Asian financial crises.Loss aversion is the tendency to bemore sensitive to reductions than toincreases in consumption.5 We showthat the government will choose tohold a relatively large stock of reservesif it believes that the populace is loss-averse. We also show that, even when

Research Summaries

Capital Account Opening, International Reserves, and Development:Evidence and Some Policy Controversies

Joshua Aizenman*

* Aizenman is a Research Associate in theNBER’s Program on International Tradeand Investment and a Professor ofEconomics at the University of California,Santa Cruz. His profile appears later inthis issue.


the return on domestic capital farexceeds the return on the safe asset, itstill can be desirable for the govern-ment to hold large reserve balances ifagents are loss-averse.

While our study is consistent withthe view that hoarding foreignexchange reserves may serve a usefulrole, all countries may not benefit fromadopting this strategy. In particular,our results suggest that the benefitsaccrue only when countries optimallycontrol both the saving of precaution-ary reserves and external borrowing.6

Attempts to focus solely on thereserves side may disappoint if theborrowing side is abused as a result ofpolitical uncertainty or corruption.7

On the Hidden Linksbetween Trade andFinancial Openness

The pragmatic case for financialreforms in the presence of growingtrade integration follows from theobservation that trade openness alsodetermines the magnitude of poten-tial financial leakage. A frequentmechanism facilitating capital flight isover-invoicing of imports and under-invoicing of exports. The scale ofthese activities is proportional to thecommercial openness of the econo-my. Curtailing illicit capital flows iscostly: it requires spending resourceson monitoring and enforcement ofthe existing capital controls. I showthat costly collection of taxes and highenough outstanding public debtimplies that financial repression in theform of capital controls would be partof the menu of taxes.8 Higher out-standing public debt and more costlycollection of taxes increase the levelof financial repression adopted by thepolicymaker. One key message fromthis framework is that greater com-mercial openness reduces the level offinancial repression chosen by devel-oping countries. This follows from theobservation that greater commercialopenness increases the effective costof enforcement of financial repres-sion, thereby reducing the usefulnessof financial repression as an implicittax. These results are consistent withthe finding that, using five-year inter-

vals and controlling for GDP/capitachanges and allowing for country-spe-cific effects, an increase in (exports+imports)/GDP of a developing coun-try is associated with a highly signifi-cant increase in financial openness (asmeasured by gross private capitalinflows plus gross private outflowsdivided by GDP). In a follow-uppaper, Noy and I use annual data andfind that financial openness in devel-oping countries depends positively onlagged trade openness and theGDP/capita, and negatively on meas-ures of democracy.9 This discussionalso implies that greater trade integra-tion increases the impetus for finan-cial reform. Yet, it also suggests thatfinancial reforms are sustainable onlyif they do not ignore the fiscal conse-quences associated with the drop infiscal revenue, and with the conse-quent increased cost of recycling thepublic debt. Hence, the sustainabilityof financial reform requires findingalternative means of taxation (orreducing government expenditure),and preferably reducing the size ofoutstanding public debt.

Dealing with VolatileCapital Flows

The discussion above implies thatgreater financial openness of emergingmarkets is the inevitable outcome ofthe growing trade integration of coun-tries. Hence, most emerging countrieswould be exposed to similar challengesas part of the growing integration withglobal markets. The prevalence offinancial crises in the 1990s has led toa re-examination of how financialmarkets function, leading to calls bysome economists for deep structuralchanges in the international financialarchitecture.10

A less aggressive approach toproviding greater stability is the impo-sition of reserve requirements onlenders and/or borrowers, as well asthe possibility of capital adequacyrequirements linked to a bank’s portfo-lio risk. The Basle committee, as wellas Fed Chairman Alan Greenspan,11

advocates this approach. The rationalefor reserve requirements is providedby the presence of various externali-

ties. On the lender’s side, the anticipa-tion of bailouts introduces an exter-nality, by which marginal lendingadversely affects the taxpayer. On theborrower’s side, as long as partialdefaults are costly, marginal borrowingaffects all agents by increasing theprobability of a costly default.12 Theintroduction of reserve requirements,either by borrowers or lenders, mayimpose better discipline on the globalfinancial market. Borrowing willdecline, but so will default risk, reduc-ing the necessity for continuedbailouts. The introduction of reserverequirements will improve welfare inboth the lending and the borrowingeconomies. In these circumstances, thelender’s optimal reserve requirementincreases with the expected bailout.Indirectly, this policy may reduce thebias in favor of debt and against equi-ty in international lending, as identifiedby Rogoff.13 But the design of the opti-mal reserve requirement in a decentral-ized world is a delicate matter. Indeed,without proper coordination among alllenders, reserve requirements wouldreallocate lending from high- to low-reserve countries, resulting in few ben-eficial effects. Hence, the gains fromsuch policies will be determined by theability of international institutions (theBIS, IMF, and others) to induce alllenders to apply similar policies, drivenby the underlying risk factors.14

Foreign Direct InvestmentFlows to DevelopingCountries andMacroeconomic Volatility

One of the more persistent andenduring forms of capital flows hasbeen foreign direct investment (FDI).This type of investment frequently ispart of a more comprehensive reallo-cation of production, and also mayinclude significant transfers of tech-nology.15 Marion and I present evi-dence showing that, controlling for arange of variables employed in the lit-erature to account for FDI, measuresof instability (such as macroeconomicvolatility, political instability, and sov-ereign risk) have a large adverse effecton FDI inflows to developing coun-tries.16 This effect is more profound


for vertical than for horizontal FDI.17

It suggests that a major obstacle pre-venting greater FDI inflows to devel-oping countries is exposure to highinflow volatility, and not necessarilythe absence of potential gains thatwould materialize in more stable cir-cumstances. We provide a model thatexplains these findings, attributing it tothe limited substitutability betweenvarious production stages in a verticalorganization of production.

In a follow up work,18 I explore theimplications of the deepening presenceof multinationals in emerging marketsfor the cost of macroeconomic volatil-ity there. I show that macroeconomicvolatility has a potentially large impacton employment and investment deci-sions of multinationals producingintermediate inputs in developingcountries. For industries with costlycapacity, the multinationals tend toinvest in the more stable emerging mar-ket/s. Higher shock volatility in a givenemerging market producing intermedi-ate inputs reduces the multinationals’expected profits. High enough instabil-ity in such a market would induce themultinationals to diversify intermediateinputs production, investing in severalemerging markets. This effect isstronger in lower margin industries.Such diversification increases theresponsiveness of the multinationals’labor requirements in each country toproductivity shocks, channeling theaverage employment from the more tothe less volatile location, and reducingthe overall multinationals’ expectedemployment in emerging markets.

Concluding Remarks

Managing volatility will remain akey challenge for emerging countries, aby-product of growing integration ofthese countries with the global econo-my. This process offers both opportu-nities and challenges. This discussionhas identified some of these issues,and illustrated the presence of mecha-nisms that may help developing coun-tries in dealing constructively withthese challenges.

1 A useful survey of financial liberalization isJ. G. Williamson and M. Mahar, A Survey

of Financial Liberalization, PrincetonEssays in International Finance, 211(November 1998). See also D. Rodrik,“Who Needs Capital-AccountConvertibility?” in P. Kenen, ed., Shouldthe IMF Pursue Capital AccountConvertibility? Essays in InternationalFinance, No. 207, Princeton: PrincetonUniversity Press, May 1998, and T.Hellmann, K. Murdock, and J. E. Stiglitz,“Liberalization, Moral Hazard in Banking,and Prudential Regulation: Are CapitalRequirements Enough?” AmericanEconomic Review, 90 (1), (2000), pp.147-65, for skeptical assessments of thegains from financial liberalization. For stud-ies dealing with the financial instability asso-ciated with capital account opening see thepapers in S. Edwards and J. A. Frankel,eds., Preventing Currency Crises inEmerging Markets, Chicago: University ofChicago Press, 2002, and M. Feldstein, ed.,Economic and Financial Crises inEmerging Market Economies, Chicago,University of Chicago Press, 2003. See J.Aizenman, “Financial Opening: Evidenceand Policy Options,” forthcoming inChallenges to Globalization, R. Baldwinand A. Winters, eds., Chicago: University ofChicago Press, for overview of the challengesassociated with financial opening. 2 J. Aizenman and N.P. Marion,“International Reserve Holdings withSovereign Risk and Costly Tax Collection,”NBER Working Paper No. 9154,September 2002, forthcoming in EconomicJournal, and “The High Demand forInternational Reserves in the Far East:What’s Going On?” NBER Working PaperNo. 9266, October 2002, Journal of theJapanese and International Eco-nomies,17(3)(September 2003).3 J. Aizenman and N.P. Marion, “The HighDemand for International Reserves in the FarEast: What’s Going On?”4 J. Aizenman and N.P. Marion,“International Reserve Holdings withSovereign Risk and Costly Tax Collection.”5 Loss aversion was identified as one of thebehavioral regularities that is inconsistentwith expected utility maximization. See A.Tversky and D. Kahneman, “Loss Aversionand Riskless Choice: A ReferenceDependence Model,” Quarterly Journal ofEconomics, 106 (1991), pp. 1039-61. Ialso illustrated that loss aversion substantial-ly increases the size and welfare gain associat-ed with the optimal level of buffer stock andprecautionary savings. See J. Aizenman,

“Buffer Stocks and Precautionary Savingswith Loss Aversion,” Journal ofInternational Money and Finance, 17(1998), pp. 931-47.6 Mismanagement of international reservesalso may deepen the financial crisis, as was thecase with Korea in 1996-7. See J. Aizenmanand N.P. Marion, “Reserve Uncertainty andthe Supply of International Credit” Journalof Money, Credit and Banking, 34 (3)(August 2002), pp. 631-49.7 A high short-term debt/internationalreserves ratio was found to be an indicator ofvulnerability, signifying exposure to crises. SeeD. Rodrik and A. Velasco, “Short-TermCapital Flows,” NBER Working PaperNo. 7364, March 2000. Our paper illus-trates that this does not imply that all emerg-ing markets would benefit by increasing thecushion of international reserves. This maybe viewed as another example of the LucasCritique, cautioning us about the hazard ofusing past data to formulate future policies. 8 J. Aizenman, “On the Hidden LinksBetween Financial and Trade Opening,”manuscript, University of California, SantaCruz, 2003.9 J. Aizenman and I. Noy, “EndogenousFinancial Openness: Efficiency and PoliticalEconomy Considerations,” manuscript,University of California, Santa Cruz,2003.10 Several recent monographs provide a com-prehensive overview of the various proposals.See B. Eichengreen, A New InternationalFinancial Architecture: A PracticalPost-Asia Agenda, Washington, D.C.:Institute for International Economics, 1999;K. Rogoff, “International Institutions forReducing Global Financial Instability,”Journal of Economic Perspectives, 13(4) (Fall 1999), pp. 21- 42; J.A. Frankeland N. Roubini, “The Role of IndustrialCountry Policies in Emerging MarketCrises,” NBER Working Paper No. 8634,December 2001; and M. Feldstein,“Economic and Financial Crises inEmerging Market Economies: Overview ofPrevention and Management,” NBERWorking Paper No. 8837, March 2002. 11 A. Greenspan, Speech at the 34th AnnualConference on Bank Structure andCompetition of the Federal Reserve Bank ofChicago, May 24, 1998.12 J. Aizenman and S. Turnovsky, “ReserveRequirements on Sovereign Debt in thePresence of Moral Hazard — on Debtors orCreditors?” The Economic Journal,(2002), pp. 107-132.


13 K.S. Rogoff, “International Institutions forReducing Global Financial Instability.”14 Alternatively, emerging markets may enactsimilar policies aimed at curbing short-termfinancial flows, akin to the Chilean system inthe nineties. See B. Eichengreen, A NewInternational Financial Architecture: APractical Post-Asia Agenda; and S.Edwards, “Exchange Rate Regimes, CapitalFlows, and Crisis Prevention.”15 See J. R. Markusen, MultinationalFirms and the Theory of International

Trade, Cambridge, MA: MIT Press, 2002,and R.C. Feenstra, Advanced Inter-national Trade: Theory and Evidence,forthcoming from Princeton University Press,2003, Chapter 11.16 J. Aizenman and N.P. Marion, “TheMerits of Horizontal versus Vertical FDI inthe Presence of Uncertainty,” manuscript,University of California, Santa Cruz,2003, forthcoming Journal ofInternational Economics. 17 A vertical pattern arises when the multina-

tional firm fragments the production processinternationally, locating each stage of produc-tion in the country where it can be done at thelowest cost. A horizontal pattern occurs whenthe multinational produces the same productor service in multiple countries. 18 J. Aizenman, “Volatility, Employment,and the Patterns of FDI in EmergingMarkets,” forthcoming, Journal ofDevelopment Economics, 2003.

At what stage of their lives aregreat innovators most creative?

There are two very differentanswers to this question. Some greatinnovators make their most importantdiscoveries suddenly, very early in theircareers. In contrast, others arrive attheir major contributions gradually,late in their lives, after decades ofwork. Which of these two life cycles aparticular innovator follows is relatedsystematically to his conception of hisdiscipline, how he works, and to thenature of his contribution.

My research on this issue beganwhen I first set out to develop quanti-tative measures of the quality of thework of important individual modernpainters over the course of their lives.1Since then, these measurements haveled not only to a new and more sys-tematic understanding of the sourcesof innovation in modern art, but alsoto a more general and comprehensiveframework for analyzing the creativityof individuals in a wide range of intel-lectual activities. After explaining theapplication of this analysis to thecareers of modern painters, this reportwill demonstrate how its implications

have illuminated the history of mod-ern art, and then will show briefly howthe analysis can be extended to innova-tors in other disciplines.

Seekers and Finders

Like important scholars, impor-tant artists are innovators.2 Great mod-ern artists can be divided into twogroups, defined according to differ-ences in their goals, methods, and con-tributions.

Painters who have producedexperimental innovations have beenmotivated by aesthetic criteria: theyhave aimed at presenting visual per-ceptions. Their goals are imprecise, sotheir procedure is tentative and incre-mental. The imprecision of their goalsmeans that they rarely feel they havesucceeded, so their careers are oftendominated by the pursuit of a singleobjective. These artists paint the samesubject many times, gradually changingits treatment by trial and error. Theyconsider the production of a paintingas a process of searching, in whichthey aim to discover the image in thecourse of making it. They build theirskills slowly over the course of theircareers, and their innovations emergepiecemeal in a body of work.

In contrast, painters who havemade conceptual innovations haveintended to communicate specific

ideas or emotions. Their goals for aparticular work can be stated preciselyin advance. They often make detailedpreparatory plans for their paintings,and execute their final works systemat-ically. Conceptual innovations appearsuddenly, as a new idea produces aresult quite different not only fromother artists’ work, but also from theartist’s own previous work. Conceptualinnovations are consequently oftenembodied in individual breakthroughpaintings. The conceptual artist’s cer-tainty about his goals, and confidencethat he has achieved them, often leaveshim free to pursue new and differentgoals. Unlike the continuity of thework of the experimental artist, con-ceptual artists’ careers are thereforeoften characterized by discontinuity.

The long periods of trial anderror usually required for importantexperimental innovations mean thatthey tend to occur late in an artist’scareer. Conceptual innovations aremade more quickly, and can occur atany age. Yet radical conceptual inno-vations depend on the ability to per-ceive and appreciate extreme devia-tions from existing practices, and thisability tends to decline with experi-ence, as habits of thought becomemore firmly established. The mostimportant conceptual innovationstherefore generally occur early in anartist’s career.

The Two Life Cycles of Human Creativity

David W. Galenson*

* Galenson is a Research Associate in theNBER’s Program on Labor Studies and aProfessor of Economics at the University ofChicago. His profile appears later in thisissue.


Archetypes

Two of the greatest modernartists epitomize the two types ofinnovator.

Paul Cézanne was an experimen-tal innovator. A month before hisdeath in 1906, the 67-year-old Cézannewrote to a friend:

“Now it seems to me that I seebetter and that I think more correctlyabout the direction of my studies. WillI ever attain the end for which I havestriven so much and so long? I hopeso, but as long as it is not attained avague state of uneasiness persistswhich will not disappear until I havereached port, that is until I have real-ized something which develops betterthan in the past... So I continue tostudy... I am always studying afternature, and it seems to me that I makeslow progress.”3

This brief passage expressesnearly all the characteristics of theexperimental artist — the visual crite-ria, the view of his enterprise asresearch, the incremental nature andslow pace of his progress, the absorp-tion in the pursuit of a vague and elu-sive goal, and the frustration with hisperceived lack of success in achievingthat goal of “realization.” The criticRoger Fry explained that Cézanne’sfrustration was a consequence of hisuncertain attitude and incrementalapproach:

For him as I understand his work,the ultimate synthesis of a design wasnever revealed in a flash; rather heapproached it with infinite precau-tions... For him the synthesis was anasymptote toward which he was forev-er approaching without ever quitereaching it.4

The irony of Cézanne’s fear offailure at the end of his life stems fromthe fact that it was his most recentwork, the paintings of his last fewyears, that would soon come to beconsidered his greatest contribution,and would directly influence everyimportant artistic development of thedecades that followed.

Unlike Cézanne, who told a friend“I seek in painting,” the leading artistof the next generation, Pablo Picasso,confidently declared “I don’t seek; Ifind.”5 In 1923 Picasso stated that:

“The several manners I have usedin my art must not be considered as anevolution or as steps toward anunknown ideal... I have never made tri-als or experiments. Whenever I havehad something to say, I have said it inthe manner in which I have felt itought to be said.”6

Generations of art historianshave commented on the abruptnessand frequency of Picasso’s stylisticchanges. One biographer made thispoint by comparing Picasso withCézanne: “There was not one Picasso,but ten, twenty, always different,unpredictably changing, and in this hewas the opposite of a Cézanne, whosework ... followed that logical, reason-able course to fruition.”7 For Picasso,new ideas brought new styles, for hisconceptual art was intended not torepresent the appearance of his sub-jects, but rather his knowledge ofthem: “I paint objects as I think them,not as I see them.”8

Picasso often planned his paint-ings carefully in advance. In 1907, atage 26, he painted Les Demoisellesd’Avignon after making more than 400studies, “a quantity of preparatorywork ... without parallel, for a singlepainting, in the entire history of art.”9

The large canvas became his mostfamous work, for it served toannounce the beginning of the con-ceptual Cubist movement, “the mostcomplete and radical artistic revolutionsince the Renaissance.”10

Quantifying ArtisticSuccess

Regression analysis of all auctionsales of paintings by Cézanne andPicasso during 1970- 97 yields the age-price profiles of Figures 1 and 2.11

Cézanne’s work rises in value to theend of his life, when he arrived at hismost radical solutions to the problemof portraying nature without sacrific-ing depth and solidity. Picasso’s mostvaluable work dates from 1907, theyear he painted the Demoisellesd’Avignon.

Figures 1 and 2 obviously reflectthe preferences of collectors. To com-pare these to the judgments of artscholars, I surveyed the paintings usedas illustrations in textbooks. An analy-sis of 33 books published in Englishrevealed that for both artists the singleyear represented by the largest numberof illustrations is the same as that esti-mated to represent the artist’s peak in


value — age 67 for Cézanne, and 26for Picasso.12 Separate analysis of 31books published in French yielded pre-cisely the same results.13

I now have used these measuresto study the careers of more than 125important modern painters. The auc-tion market and the textbooks almostalways agree closely on when thepainter produced his best work.14

Analysis of these painters’ workingmethods, and of the nature of theirinnovations, furthermore, reveals thattheir life cycles almost always followthe predicted pattern: painters whoworked experimentally have nearlyalways produced their best work late intheir careers, whereas those whoseinnovations were conceptual havenearly always made their greatest con-tributions early. Thus such majorexperimental painters as CamillePissarro, Edgar Degas, WasilyKandinsky, Georgia O’Keeffe, JeanDubuffet, Mark Rothko, and Willemde Kooning all reached their peakachievements after the age of 40. Incontrast, such important conceptualinnovators as Georges Seurat, Henride Toulouse-Lautrec, Georges Braque,Juan Gris, Giorgio de Chirico, Jasper

Johns, and Frank Stella all made theirgreatest contributions before the ageof 30.15

Masters and MasterpiecesRecognition of the differences in

methods and products between exper-imental and conceptual painters helpsto resolve a number of puzzles in the

history of modern art. One of theseinvolves a discrepancy between thegreatest painters and the greatestpaintings. Specifically, if we rank bothpainters and paintings according tototal illustrations in textbooks, we findthat some of the most importantartists failed to produce importantindividual works, while some of themost important paintings were pro-duced by painters who do not rankamong the very most importantartists.16

The analysis provided here pointsto the explanation. Great experimen-tal painters, like Cézanne, Degas, andMonet, innovated gradually, makingmany small changes in their techniqueover the course of extended periodsand many canvases, and their greatestcontributions were not embodied in

individual breakthrough works.Consequently, there is no consensuson which of their paintings best illus-trates their achievements. In contrast,conceptual innovations normally aredeclared in specific breakthroughworks. Thus at the age of 27 Seuratspecifically designed Sunday Afternoonon the Island of the Grande Jatte to illus-trate his scientific approach to the useof color, and it became the mostfamous painting executed in the nine-teenth century. Two decades later the25-year-old Marcel Duchamp paintedNude Descending a Staircase to demon-strate his conception of the static rep-resentation of movement, and itbecame the third most famous paint-ing produced in the twentieth century,behind only the Demoiselles d’Avignonand another landmark work, Guernica,by the conceptual Picasso. So the puz-zle is resolved: important conceptualpainters produce famous individualmasterpieces, but great experimentalpainters do not, instead producingimportant bodies of work.

Beyond Modern Art

The implications of this researchgo beyond modern art. It is now clearthat this analysis can be applied equal-ly to great painters of the pre-modernera: Masaccio, Raphael, and Holbeinwere conceptual artists, whereasLeonardo, Titian, Michelangelo, andRembrandt were experimental.17 Butthe applicability of the analysis goesbeyond art in general, for I believe thatin virtually all intellectual activitiesthere are important practitioners ofboth types described here, and that inall these activities there are conse-quently two distinct life cycles of cre-ativity.

Results from studies of innova-tors in three other disciplines providesupport for this belief. One of thesestudies analyzes the life cycles ofNobel laureates in economics.Whereas such theorists as KennethArrow, Gary Becker, Paul Samuelson,and Robert Solow all published theirmost often cited work before the ageof 35, the empiricists Simon Kuznetsand Theodore Schultz both publishedtheir most-cited work after the age of50. Economic theorists work deduc-


tively, and innovate conceptually, whilein contrast the empiricists Kuznets andSchultz worked inductively, and inno-vated experimentally.18

A second related study examinesthe careers of important modernAmerican poets. The production ofgreat poetry often is considered to bethe exclusive domain of the young.19

But quantitative analysis of individualcareers contradicts this belief. By themeasure of poems reprinted inanthologies, the careers of E. E.Cummings, T. S. Eliot, Ezra Pound,and Richard Wilbur were dominatedby the work of their 20s and 30s, butin contrast Elizabeth Bishop, RobertFrost, Robert Lowell, MarianneMoore, Wallace Stevens, and WilliamCarlos Williams all produced theirmajor work in their 40s and beyond.The elegant and sophisticated poetryof Cummings, Eliot, Pound, andWilbur grew primarily out of imagina-tion and study of literary history, andwas formulated conceptually, whileBishop, Frost, Lowell, Moore, Stevens,and Williams produced poetry rootedin real speech and experience, drawingon the observed reality of their dailylives to innovate experimentally.20

A third related study shows thatthe careers of great modern novelistshave followed these same two patterns.Herman Melville, D.H. Lawrence, F.Scott Fitzgerald, and Ernest Hemingwaywrote with confidence and clarity ofpurpose to express their ideas and emo-tions, and produced conceptual master-pieces early in their careers. In contrast,Charles Dickens, Mark Twain, HenryJames, Virginia Woolf, and WilliamFaulkner worked tentatively towardbetter representations of the worldthey knew, and arrived at their greatestcontributions only after decades ofexperimentation.21

The full implications of thisresearch appear to be considerable,and remain to be pursued throughstudy of innovators in other disci-plines. The implications involve notonly substance but also method, forthe results I have obtained suggestthat, contrary to the tendency of econ-omists to study the life cycle only forgroups of workers, it may be of con-siderable value to study the careers of

important individual innovators. Thiswork may eventually give us a moresystematic understanding of humancreativity wherever it occurs — inartists’ studios, scholars’ studies, orcomputer scientists’ cyberspace.

1 D. W. Galenson, “The Careers of ModernArtists: Evidence from Auctions ofContemporary Paintings,” NBER WorkingPaper No. 6331, December 1997, and inJournal of Cultural Economics, 24(2000), pp. 87-112.2 For discussion see D. W. Galenson,Painting outside the Lines: Patterns ofCreativity in Modern Art, Chapter 4,Cambridge: Harvard University Press,2001.3 P. Cézanne, Letters, New York: Da CapoPress, 1995, pp. 329-30.4 R. Fry, Cézanne, Chicago: University ofChicago Press, 1989, p. 3.5 R. Shiff, Cézanne and the End ofImpressionism, Chicago: University ofChicago Press, 1984, p. 222; F. Gilot andC. Lake, Life with Picasso, New York:Doubleday, 1964, p. 199.6 A. H. Barr, Jr., Picasso, New York:Museum of Modern Art, 1946, p. 271.7 P. Cabanne, Pablo Picasso, New York:William Morrow, 1977, p. 272.8 J. Golding, Cubism, London: Faber andFaber, 1959, p. 60.9 W. Rubin, H. Seckel, and J. Cousins, LesDemoiselles d'Avignon, New York:Museum of Modern Art, 1994, pp. 14,119.10 See J. Golding, Cubism, p. 15.11 D. W. Galenson, “The Lives of thePainters of Modern Life: The Careers ofArtists in France from Impressionism toCubism,” NBER Working Paper No.6888, January 1999.12 D. W. Galenson, “Quantifying ArtisticSuccess: Ranking French Painters — andPaintings — from Impressionism toCubism,” NBER Working Paper No.7407, October 1999, and in HistoricalMethods, 35 (2002), pp. 5-20.13 D. W. Galenson, “Measuring Masters andMasterpieces: French Rankings of FrenchPainters and Paintings from Realism toSurrealism,” NBER Working Paper No.8266, May 2001, and in Histoire &Mesure, 17 (2002), pp. 47-85.14 D. W. Galenson, Painting outside theLines, Appendixes A and B; D. W.Galenson and B. A. Weinberg, “Age and the

Quality of Work: The Case of ModernAmerican Painters,” NBER WorkingPaper No. 7122, May 1999, and inJournal of Political Economy, 108(2000), pp. 761-77.15 D. W. Galenson, “The Life Cycles ofModern Artists: Theory, Measurement, andImplications,” NBER Working Paper No.9539, March 2003; D. W. Galenson, “WasJackson Pollock the Greatest ModernAmerican Painter? A QuantitativeInvestigation,” NBER Working Paper No.8830, March 2002, and in HistoricalMethods, 35 (2002), pp. 117-28; D. W.Galenson, “The Life Cycles of ModernArtists,” NBER Working Paper No.8779, February 2002, and in WorldEconomics, 3 (2002), pp. 161-78; D. W.Galenson, “The New York School vs. theSchool of Paris: Who Really Made the MostImportant Art After World War II?”NBER Working Paper No. 9149,September 2002, and in HistoricalMethods, 35 (2002), pp. 141-53.16 D. W. Galenson, “Masterpieces andMarkets: Why the Most Famous ModernPaintings are not by American Artists,”NBER Working Paper No. 8549, October2001, and in Historical Methods, 35(2002), pp. 63-75; D. W. Galenson, “TheDisappearing Masterpiece,” WorldEconomics, 3 (2002), pp. 9-24.17 D. W. Galenson and R. Jensen, “YoungGeniuses and Old Masters: The Life Cyclesof Great Artists from Masaccio to JasperJohns,” NBER Working Paper No. 8368,July 2001; R. Jensen, “Anticipating ArtisticBehavior : New Research Tools for ArtHistorians,” unpublished paper, Universityof Kentucky.18 D. W. Galenson and B. A. Weinberg,“Creative Careers: Age and Creativityamong Nobel Laureate Economists,” inpreparation.19 See, for example, H. C. Lehman, Ageand Achievement, Princeton: PrincetonUniversity Press, 1953, p. 249; H.Gardner, Creating Minds, New York:Basic Books, 1993, p. 248; F. Kermode, ed.,Selected Prose of T. S. Eliot, New York:Harcourt Brace Jovanovich, 1975, p. 252.20 D. W. Galenson, “Literary Life Cycles:The Careers of Modern American Poets,” inpreparation.21 D. W. Galenson, “A Portrait of theArtist as a Young or Old Innovator :Measuring the Careers of ModernNovelists,” forthcoming, 2003.


In public economics the conven-tional wisdom has been that taxes oncapital income generate high efficiencycosts with few offsetting benefits.1

Average tax rates on the return to capi-tal are measured to be very high,2 as aremarginal tax rates on savings andinvestment.3 There is a large body ofresearch indicating that these high capi-tal taxes have important effects on therate of corporate investment, on theallocation of capital across uses, onwhether profits are reported in theUnited States or offshore, and on cor-porate and personal financial decisions.4

Consistent with these forecasts ofvery high efficiency costs, Slemrod andI find that tax revenue would havebeen virtually unchanged if the UnitedStates had shifted in 1983 to an R-baseunder the personal and corporateincome tax, thereby exempting capitalincome from tax.5 Thus, adjustmentsthat taxpayers made to reduce their taxliabilities were extensive enough towipe out all tax revenue from taxes oncapital income.

Are there any obvious distribu-tional benefits that compensate forthese high efficiency costs? At least ina small open economy, the answer isno.6 Capital can easily escape taxationby going abroad, so that domesticworkers, rather than capital, end upbearing taxes imposed on capital.Even if the economy is closed,Atkinson and Stiglitz argued, there areno distributional gains from taxing thereturn to savings as long as utility func-tions are weakly separable betweenleisure and consumption.7

Using data from 1983, Slemrodand I examined the distribution ofgains and losses to individuals thatwould result from shifting to an R-base. We found that the existing U. S.

tax system, relative to an R-base,imposed higher taxes on lower-incomeinvestors, who largely invest in taxablebonds, while imposing lower taxes onhigher-income investors, who borrowheavily to buy more lightly taxedassets. These results suggest that theexisting tax treatment of capitalincome has perverse distributionaleffects.

Thus, capital income taxes havelarge efficiency costs, collect little rev-enue, and have no obvious distribu-tional gains. So, the case for usingthem appears to be very weak. Yetactual tax rates on capital incomeremain high, implying a sharp contrastbetween theory and practice. A majorfocus of my research during the lastfew years has been to look more close-ly at these above arguments, to see ifthere are important omissions fromthe theory that could call into questionits implications for capital incometaxes.

Capital Immobility

One questionable assumption ofthe standard model is that the UnitedStates is a small open economy. Asdocumented by French and Poterba8,individual portfolios show strong“home bias:” investors invest far morein financial securities from their owncountries than can be explained easily,given the standard forecast of world-wide portfolio diversification. However,the implications of capital immobilityfor tax policy depend on why capital isimmobile.

One possible reason for homebias in portfolios is real exchange raterisk. Gaspar and I examine the impli-cations of random fluctuations in therelative values of goods produced indifferent countries for both portfoliochoice and tax policy.9 If random rel-ative values of goods are reflected inrandom fluctuations of the domesticprice level but stable exchange rates,then the model forecasts substantial

home bias in equity portfolios, as ahedge against random consumerprices. But since domestic investorsbuy equity as a hedge, they end upbearing too much production riskfrom domestic firms. Capital taxesexacerbate this misallocation of risk-bearing. The fact that capital is immo-bile does not make taxation of capitalincome a plausible policy per se.

Distributional Effects

In two other recent papers, Ireexamine whether the distributionaleffects of capital income taxes are asperverse as has been argued.Kalambokidis, Slemrod, and I (here-after GKSb) recalculated the distribu-tional effects of capital income taxesfound in my 1988 paper with Slemrod,using data from 1995.10 In spite of themajor tax reform in 1986, the data for1995 still imply rather perverse distrib-utional effects of existing taxes, rela-tive to an R-base. Lower income indi-viduals still lose, middle income indi-viduals still gain, and more so the high-er their income, but now the highestincome group also loses from taxes oncapital income.

In another recent paper, I lookedmore carefully at the distributionaleffects of existing taxes on interestincome/payments in a standard theo-retical setting.11 Unlike GKSb, thisstudy accounts for changes in assetprices. Interest income has faced ahigher effective tax rate than any othersource of income from savings,because the nominal income is fullytaxable. Yet at least in a closed econo-my, high taxation may provide distrib-utional gains. To begin with, taxes oninterest income cause the market-clearing interest rate to rise, helpinglower income lenders and hurtinghigher-income creditors. Yet this redis-tribution has no efficiency cost at themargin, starting from a situation withno distortions to portfolio choice, sothat it dominates using additional taxes

* Gordon is a Research Associate in theNBER’s Program on Public Economics anda Professor of Economics at University ofCalifornia, San Diego. His profile appearslater in this issue.

Capital Income Taxes

Roger H. Gordon*


on earnings to redistribute income. Inaddition, if higher ability individualsinvest more in equity, even given theirlabor income, then portfolio distor-tions can help redistribute from moreable to less able individuals.

In GKSb we also reestimated therevenue collected from existing taxes onincome from savings and investment.In contrast to the earlier results for1983, we find in 1995 that these taxescollected additional revenue of $91.7billion, now positive but still very small.

Efficiency Costs

The fact that so little revenue iscollected in principle could imply thatthe effective tax rate on capital invest-ment is low. Kalambokidis, Slemrod,and I (hereafter GKSa) develop a theo-retical model to explore the linksbetween the revenue collected fromthese taxes and the size of the resultingdistortion discouraging capital invest-ment.12 In a standard setting, there is asimple formula to go from one to theother. Since very little revenue is col-lected from capital taxes, the GKSaformula implies a very low effective taxrate on new investment. Apparently,investors use tax avoidance strategiesnot accounted for in the standard user-cost formula (as in King, Fullerton) sothat the revenue collected on a margin-al investment is found to be very low.13

But tax avoidance itself can have highefficiency costs.

One mechanism for tax avoid-ance is debt arbitrage: investors andfirms in high tax brackets borrowheavily from investors in low taxbrackets in order to buy lightly taxedassets. Economists have found it veryhard to test this forecast. Time-seriesevidence is unrevealing, because taxrates change so seldom, while cross-section evidence on publicly tradedfirms (reported in Compustat) worksbadly because effective tax rates varyamong publicly traded firms largely forreasons that can independently affectfirm borrowing behavior. Lee and Iinstead use published data from corpo-rate tax returns for all corporationsover 37 years, reported separately forvarious size categories of firms, to testwhether firms borrow more when

their tax rate is relatively high.14 Eventhough the top corporate tax rate hasnot changed much over time, corpo-rate tax rates on lower levels of earn-ings have changed frequently, allowingus to identify the effects of taxes byseeing how the relative use of debtchanges for small versus large firms astheir relative tax rates change. We findquite large effects. For example, cut-ting the corporate tax rate by fivepoints (from 35 percent to 30 percent),holding personal tax rates fixed, is pre-dicted to cause a shift from debt toequity finance of 2 percent of corpo-rate assets.

Another mechanism for taxavoidance is income shifting betweenthe corporate and personal tax bases.When personal and corporate tax ratesdiffer, firms with profits tend tochoose the organizational form thathas a lower tax rate on profits, whilefirms with losses choose the form thatallows them to deduct their losses sub-ject to a higher tax rate. This incomeshifting was the basis for the tax shel-ter industry in the 1980s. Slemrod andI provided evidence on the extent ofthis income shifting by looking at howreported corporate rates of returnhave changed over time in response todifferences between corporate andpersonal tax rates.15 We found substan-tial evidence of income shiftingbetween the corporate and personaltax bases.

While debt arbitrage and incomeshifting both appear to be very respon-sive to tax incentives, the efficiencycost arising from tax distortions tothese choices appears to be small,because the size of the tax distortionaffecting each choice is typically small.In fact, I point out a potential efficien-cy gain from the difference in corpo-rate versus personal tax rates, throughthe resulting subsidy to entrepreneurialactivity.16 Given the option to incorpo-rate, firms can take advantage of thelower corporate tax rates when theyare profitable and the higher personaltax subsidy for losses when they areunprofitable. Undertaking added riskthen lowers expected taxes, implying anet subsidy to risk-taking.

Cullen and I examine how theinteraction between the personal andcorporate tax schedules, and tax incen-

tives more broadly,17 affect individuals’incentives to become entrepreneurs.We measure entrepreneurial activity bythe presence of noncorporate losses.Estimated effects, using data on indi-vidual tax returns from 1964 to 1993,are remarkably large. For example, ashift to a 20 percent flat tax is forecastto virtually triple the rate of entrepre-neurial activity.

Capital Taxation by LocalGovernments

This discussion has focused onnational taxes on capital income. Anydiscussion of subnational taxes oncapital also has to take into account thepossibility that individuals migrateacross jurisdictions in response to taxchanges. Individual migration deci-sions depend on differences in govern-ment expenditures as well as on differ-ences in taxes. Wilson and I examinethe effects of a marginal change inlocal property taxes. We find that theeffect of raising taxes and expendi-tures together causes a drop in housingconsumption per household but anincrease in the number of householdssufficient enough to leave the equilib-rium housing stock unchanged.18 Inthis setting, in contrast to a settingwithout migration, taxation of capitaldoes not discourage capital investment.

We argue further that use of theproperty tax gives favorable incentivesto local government officials: by pro-viding higher quality local public serv-ices, property values and property taxpayments both rise, so the budget con-trolled by local officials gets larger.The property tax thus can yield effi-ciency gains through improved incen-tives for public officials.19

Tax Evasion

These papers largely ignore taxevasion. Yet in poorer countries,underreporting of capital income iswidespread: often only a small fractionof the economic income that in princi-ple is taxable ever gets reported. Li andI document one possible response tothis problem that the China govern-ment used during the 1990s.20 Ratherthan taxing interest income, the


Chinese government restricted theinterest rate that it paid on bankdeposits. Rather than taxing theincome of corporate shareholders, thegovernment restricted the supply ofequity to the market, and collectedhigher revenue from the issuance ofnew shares. In theory, these regulationsare equivalent to capital income taxes,yet they can be much easier to enforce.

Offsetting Subsidies

I recently noted that distortioncosts from taxes on capital income canbe avoided in part through subsidizedcredit for new investment projects,coming perhaps from a state-ownedbank.21 While not something observedin the United States, directed credit hasbeen common in Europe. When capi-tal tax rates are sufficiently high, evenpoorly informed government subsidiesto new investment may lessen the effi-ciency costs of these high tax rates.

Summary

Taken together, these papersprovide a much less stark view of therole for capital income taxes, suggest-ing some distributional gains, smallerefficiency costs than have beenclaimed in the past, and even some rea-sons for efficiency gains from thesetaxes. In sum, theory and practice maynot be as dramatically different as theyhave appeared.

1 For a summary of these arguments, see R.H. Gordon, “Taxation of Capital Income vs.Labour Income: An Overview,” in TaxingCapital Income in the European Union:Issues and Options for Reform, S.Cnossen, ed., Oxford: Oxford UniversityPress, 2000.2 See, for example, M. Feldstein and L. H.Summers, “Is the Rate of Profit Falling?”Brookings Papers on EconomicActivity, 1977, pp. 211-27; and E. G.Mendoza, A. Razin, and L. Tesar, “EffectiveTax Rates in Macroeconomics: Cross-Country Estimates of Tax Rates on FactorIncome and Consumption,” Journal ofMonetary Economics, 34 (1994), pp.297-323.3 See, for example, M. A. King and D.Fullerton, eds., The Taxation of Income

from Capital: A Comparative Study ofthe United States, the UnitedKingdom, Sweden, and WestGermany,” Chicago: University of ChicagoPress, 1984. 4 For recent surveys of this literature, see thechapters by Poterba, Bernheim, Auerbach,and Hassett-Hubbard, and Gordon-Hines inA. J. Auerbach and M. Feldstein,Handbook of Public Economics, Vol3 and 4, New York: Elsevier, 2002. 5 As defined by the Meade Commission, anR-base allows new investment to be immedi-ately expensed rather than depreciated, andeliminates all taxes on net income from finan-cial securities. See The Structure andReform of Direct Taxation, MeadeCommittee Report, Boston: Allen & Unwin,1978; and R. H. Gordon and J. Slemrod,“Do We Collect any Revenue from TaxingCapital Income?” in Tax Policy and theEconomy, 2 (1988), pp. 89-130. 6 See, for example, R. H. Gordon,“Taxation of Investment and Savings in aWorld Economy,” American EconomicReview, 76 (1986), pp. 1086-102. 7 In this case, individuals with the same laborincome have the same consumption patterns,regardless of their underlying ability. If thegoal is to tax unobserved ability, then taxingboth labor and capital income is no more effec-tive than taxing only labor income, yet intro-duces added distortions. See A. B. Atkinsonand J. E. Stiglitz, “The Design of TaxStructure: Direct versus Indirect Taxation,”Journal of Public Economics, 6 (1976),pp. 55-75.8 K. R. French and J. M. Poterba, “InvestorDiversification and International EquityMarkets,” in Advances in BehavioralFinance, R. Thaler, ed., New York:Russell Sage Foundation, 1993.9 R. H. Gordon and V. Gaspar, “HomeBias in Portfolios and Taxation of AssetIncome,” NBER Working Paper No. 8193,March 2001, and in Advances inEconomic Analysis & Policy, 1 (2001),pp. 1-28. Also reprinted in EconomicPolicy in the International Economy,E. Helpman and E. Sadka, eds., 2002.10 R. H. Gordon, L. Kalambokidis, and J.Slemrod “Do We Now Collect any Revenuefrom Taxing Capital Income,” NBERWorking Paper No. 9477, February 2003,forthcoming in Journal of PublicEconomics.11 R. H. Gordon, “Taxation of InterestIncome,” NBER Working Paper No. 9503,February 2003, forthcoming in

International Tax and Public Finance. 12 R. H. Gordon, L. Kalambokidis, and J.Slemrod, “A New Summary Measure of theEffective Tax Rate on Investment,” NBERWorking Paper No. 9535, March 2003,forthcoming in Tax Burden on Capitaland Labor, P. Birch Sorensen, ed. 13 GKSa does show that for some more com-plicated distortions, for example to portfoliochoice, the true effective tax rate on investmentshould be between the figures implied byGKSa and King-Fullerton.14 R. H. Gordon and Y. Lee, “Do TaxesAffect Corporate Debt Policy? Evidencefrom U.S. Corporate Tax Return Data,”NBER Working Paper No. 7433,December 1999, and in Journal of PublicEconomics, 82 (2001), pp. 195-224.15 R. H. Gordon and J. Slemrod, “Are ‘Real’Responses to Taxes Simply Income Shiftingbetween Corporate and Personal TaxBases?” NBER Working Paper No. 6576,May 1998, in Does Atlas Shrug: TheEconomics of Taxing the Rich, J.Slemrod, ed., 2000, New York: RussellSage Foundation.16 R. H. Gordon, “Can High Personal TaxRates Encourage Entrepreneurial Activity?”IMF Staff Papers, 45 (1998), pp. 49-80. 17 For example, progressive tax schedules dis-courage risk taking; risk sharing with the gov-ernment can facilitate risk taking; while thepayroll tax encourages entrepreneurial activity,because successful entrepreneurs can avoid thistax by incorporating and then receiving theirincome in the form of capital gains rather thanwages. See J. B. Cullen and R. H. Gordon,“Taxes and Entrepreneurial Activity: Theoryand Evidence for the U.S.,” NBERWorking Paper No. 9015, June 2002.18 R. H. Gordon and J. D. Wilson,“Expenditure Competition,” NBERWorking Paper No. 8189, March 2001,and in Journal of Public EconomicTheory, 5 (2003), pp. 399-418. 19 R. H. Gordon and J. D. Wilson, “TaxStructure and Government Behavior :Implications for Tax Policy,” NBERWorking Paper No. 7244, July 1999. 20 R. H. Gordon and W. Li, “Governmentas a Discriminating Monopolist in theFinancial Market: The Case of China,”NBER Working Paper No. 7110, May1999, and in Journal of PublicEconomics, 87 (2003), pp. 283-312.21 R. H. Gordon, “Taxes andPrivatization,” in Public Finance andPublic Policy in the New Century, S.Cnossen, ed., 2003.


NBER Profile: David Galenson

David W. Galenson is a ResearchAssociate in the NBER’s Program onLabor Studies and a Professor ofEconomics at the University of Chicago.He received both his undergraduate andhis graduate degrees in economics fromHarvard University.

Galenson joined the University ofChicago’s economics faculty in 1978 andwas promoted to full professor in 1986.He has also been a visiting professor atl'Ecole des Hautes Etudes en SciencesSociales, the University of Texas at Austin,MIT, California Institute of Technology,and the American University of Paris.

Galenson’s work, earlier in his career ineconomic history and more recently onthe economics of the art world, is widelypublished in economic journals. He alsohas authored a number of books, includ-ing Painting Outside the Lines: Patterns ofCreativity in Modern Art, which was pub-lished in 2001, and Mesurer l’Art, which willbe published in 2004.

Galenson lives in Chicago with LynnOlson, a sociologist who works at theAmerican Academy of Pediatrics. Whenhe is not working, he enjoys playing tennisand collecting modern art.

NBER Profile: Joshua Aizenmann

Joshua Aizenman is a ResearchAssociate in the NBER's Program onInternational Trade and Investment and aProfessor of Economics at the Universityof California, Santa Cruz (UCSC). Hereceived his B.A. in Mathematics andPhilosophy and M.A. in Economics fromHebrew University, Jerusalem, and his Ph.D. in Economics from the University ofChicago.

Aizenman joined the faculty at UCSCin 2001 following eleven years atDartmouth College, where he had servedas the Champion Professor ofInternational Economics. His researchcovers a range of issues in open economy,including commercial and financial poli-

cies, crises in emerging markets, foreigndirect investment, capital controls, andexchange rate regimes. His other affilia-tions have included teaching and researchpositions at the University ofPennsylvania, the University of ChicagoGraduate School of Business, and theHebrew University in Jerusalem. He hasalso served as a consultant to the WorldBank, the Federal Reserve Bank of SanFrancisco, the International MonetaryFund, and the Inter-AmericanDevelopment Bank.

Aizenman was born in Poland and hasjoint U.S./Israeli citizenship. He is mar-ried and has four children.


NBER Profile: Roger H. Gordon

Roger H. Gordon is a ResearchAssociate in the NBER’s Program inPublic Economics and a Professor ofEconomics at the University ofCalifornia, San Diego (UCSD). His cur-rent research interests include positiveand normative issues in the taxation offinancial and real investments, and taxissues in transition and developingcountries.

Gordon received his B.A. fromHarvard and his Ph.D. at MIT. Beforemoving to UCSD, he was the ReubenKempf Professor at the University of

Michigan, and earlier was on the techni-cal staff at Bell Laboratories. He is aFellow of the Econometrics Society, apast editor and current co-editor of theJournal of Public Economics, and a past co-editor of the American Economic Review.

Gordon lives in La Jolla with his wife,NBER Research Associate Michelle J.White. When they are not working, theylike to hike and bike in the hills aroundSan Diego. They also enjoy spendingtime abroad, and at this point havespent time at research institutes in overten different countries.

*


Conferences

Frontiers in Health Policy ResearchThe NBER’s seventh annual con-

ference on “Frontiers in HealthPolicy Research,” organized byDavid M. Cutler, NBER andHarvard University, and Alan M.Garber, NBER and StanfordUniversity, took place on June 6 inWashington, DC. The program was:

Patricia M. Danzon, NBER andUniversity of Pennsylvania, andJonathan D. Ketcham, Universityof California, Berkeley, “ReferencePricing of Pharmaceuticals:Evidence from Germany, theNetherlands, and New Zealand”

Mark V. Pauly, NBER andUniversity of Pennsylvania,“Adverse Selection and theChallenges to Stand-AlonePrescription Drug Insurance”

Wiliam H. Crown and JonathanMaguire, Medstat; Ernst Berndt,NBER and MIT; and Kenneth E.Haver and Whitney P. Witt,Massachusetts General Hospital,“Benefit Plan Design andPrescription Drug UtilizationAmong Asthmatics: Do PatientCopayments Matter?”

Jay Bhattacharya, NBER andStanford University; David M.Cutler; Dana Goldman, MichaelHurd, and Darius Lakdawalla,NBER and Rand Corporation; andConstanjin Panis, RandCorporation, “Disability Forecastsand Future Medicare Costs”

Nancy Beaulieu, NBER andHarvard University, “Health PlanConversions: Are they in the PublicInterest?”

Danzon and Ketcham describethree prototypical systems of thera-peutic reference pricing (RP) for phar-maceuticals — Germany, theNetherlands, and New Zealand — andexamine their effects on: the availabili-ty of new drugs; manufacturer prices,reimbursement levels, and out-of-pocket surcharges to patients; andmarket shares of originator and gener-ic products. The results differ acrosscountries in predictable ways, depend-ing on system design and other costcontrol policies. The most aggressiveRP system has severely limited theavailability of new drugs, particularlymore expensive drugs, disproportion-ately reduced reimbursement and salesfor originator products, and exposedpatients to out-of-pocket costs. Theauthors find little evidence that thera-peutic referencing has stimulated com-petition.

Pauly investigates a possible pre-dictor of adverse selection problems inunsubsidized “stand-alone” prescrip-tion drug insurance: the persistence ofan individual’s high spending over mul-tiple years. Using MEDSTAT claimsdata and data from the Medicare sur-vey of Current Beneficiaries, he findsthat persistence is much higher for

outpatient drug expenses than forother categories of medical expenses.He then uses these estimates to devel-op a model of adverse selection incompetitive insurance markets and toshow that this high relative persistencemakes it unlikely that unsubsidizeddrug insurance can be offered for sale,even with premiums partially adjustedfor risk, without a probable adverseselection death spiral. This outcomecan be avoided if drug coverage isbundled with other coverage, andPauly briefly discusses the need forcomprehensive coverage or generoussubsidies if adverse selection is to beavoided in private and Medicare insur-ance markets.

The ratio of controller-to-relievermedication use has been proposed asone measure of treatment quality forasthma patients. Crown and his co-authors examine the effects of plan-level, mean, out-of-pocket patientcopayments for asthma medication,and other features of benefit plandesign, on the use of controller med-ications alone, controller and relievermedications together (combinationtherapy), and reliever medicationsalone, relative to no drug treatment.They use claims data for 1995-2000.

They find that the controller-relieverratio rose steadily over 1995-2000,along with out-of-pocket payments forasthma medications. However, aftercontrolling for other variables, planlevel mean out-of-pocket copaymentswere not found to have a statisticallysignificant influence on patient-levelasthma treatment patterns. On theother hand, prescribing patternsamong providers did influence patient-level treatment patterns; these effectsdiffer somewhat between fee for serv-ice versus non-fee for service plans.

The traditional focus of disabilityresearch has been on the elderly, withgood reason. Chronic disability ismuch more prevalent among the elder-ly, and it has more direct impact on thedemand for medical care. However, itis also important to understand trendsin disability among the young, particu-larly if these trends diverge from thoseamong the elderly. These trends couldhave serious implications for futurehealth care spending, since more dis-ability at younger ages almost certainlytranslates into more disability amongtomorrow’s elderly, and disability is akey predictor of health care spending.Using data from the Medicare CurrentBeneficiary Survey and the National


Health Interview Study, Bhattacharyaand his co-authors forecast that percapita Medicare costs will decline forthe next 15 to 20 years; this is in accor-dance with recent projections ofdeclining disability among the elderly.However, by 2020, the trend reverses.Per capita costs begin to rise becauseof growth in disability among theyounger elderly. Total costs, which arethe product of per capita costs and thetotal Medicare-eligible elderly popula-tion, will then begin to grow at anaccelerating rate. Overall, cost fore-casts for the elderly that incorporateinformation about disability amongtoday’s younger generations yield morepessimistic scenarios than those basedsolely on elderly datasets; this informa-tion should be incorporated into offi-cial Medicare forecasts.

Over the last decade, managedcare companies have been consolidat-ing on a regional and a national scale.

More recently, not-for-profit healthplans have been converting to for-profit status; frequently, this conver-sion has occurred as a step towardfacilitating a merger or acquisition witha for-profit company. Beaulieu exam-ines certain related health policy issuesthrough the lens of a case study of theproposed conversion of the CareFirstBlue Cross-Blue Shield Company to afor-profit public stock company, andits merger with the WellpointCorporation. Company executives andboard members argued that CareFirstlacked access to sufficient capital andfaced serious threats to its viability as afinancially healthy non-profit healthcare company. They further arguedthat CareFirst and its beneficiarieswould benefit from merger throughenhanced economies of scale andproduct line extensions. Critics of theproposed conversion and mergerraised concerns about the adverse

impacts on access to care, coverageavailability, quality of care, safety netproviders, and the cost of health insur-ance.

Analyses demonstrate thatCareFirst wields substantial marketpower in its local market, that it isunlikely to realize cost savings throughexpanded economies of scale, and thataccess to capital concerns are largelydriven by the perceived need for fur-ther expansion through merger andacquisition. Though it is impossible topredict future changes in quality ofcare for CareFirst, analyses suggestthat quality appears to be somewhatlower in for-profit national managedcare companies.

These papers will be published bythe MIT Press in an annual conferencevolume. They are also available at“Books in Progress” on the NBER’swebsite under the title Frontiers inHealth Policy Research, Volume 7.

*


History of Corporate Ownership: The Rise and Fall of GreatBusiness Families

The NBER held a conferenceon “The History of CorporateOwnership: The Rise and Fall ofGreat Business Families” in Alberta,Canada on June 21-22. NBERResearch Associate Randall Morck,University of Alberta, organized thisprogram:

Randall Morck; Michael Percyand Gloria Tian, University ofAlberta; and Bernard Yeung, NewYork University, “The Rise and Fallof the Widely Held Firm inCanada”Discussant: Jordan Siegel, MIT

William N. Goetzmann, NBERand Yale University, and ElisabethKöll, Case Western ReserveUniversity, “The History ofCorporate Ownership in China”Discussant: Dwight Perkins,Harvard University

Tarun Khanna and KrishnaPalepu, Harvard University,“Decision or Serendipity? The Riseof India’s Software Industry”Discussant: Ashoka Mody,

International Monetary Fund

Antoin E. Murphy, Trinity CollegeDublin, “The History of CorporateOwnership in France”Discussant: Daniel Raff, NBERand University of Pennsylvania

Caroline Fohlin, CaliforniaInstitute of Technology,“Ownership and Control inGerman Corporations: A Long-Run Perspective on the Role ofBanks”Discussant: Alexander Dyck,Harvard University

Julian Franks and Stefano Rossi,London Business School, andColin Mayer, University ofOxford, “The Origination andEvolution of Ownership andControl”Discussant: Barry Eichengreen,NBER and University ofCalifornia, Berkeley

Alexander Aganin, CornerstoneResearch, and Paolo Volpin,London Business School, “The

History of Corporate Ownership inItaly”Discussant: Daniel Wolfenzon,New York University

Randall Morck, and MasaoNakamura, University of BritishColumbia, “The History ofCorporate Ownership in Japan”Discussant: Sheldon Garon,Princeton University

Peter Högfeldt, Stockholm Schoolof Economics, “The History andPolitics of Corporate Ownership inSweden”Discussant: Ailsa Röell, PrincetonUniversity

Marco Becht, Université Libre deBruxelles, and J. BradfordDeLong, NBER and University ofCalifornia, Berkeley, “Why hasthere been so Little Blockholding inAmerica?”Discussant: Richard Sylla, NBERand New York University

A long panel of corporate owner-ship data, stretching back to 1910,shows that the Canadian corporatesector began the century with a pre-dominance of large pyramidal corpo-rate groups controlled by wealthy fam-ilies or individuals, and relatively fewwidely held firms. By the middle of thecentury, widely held firms had becomepredominant. However, from the1970s on, there has been a markedresurgence of pyramidal groups con-trolled by wealthy families and individ-uals, corresponding to a large declinein the prevalence of widely held firms.Morck, Percy, Tian, and Yeung notethat improvements in the general insti-tutional environment and high taxeson inherited income accompany therise of widely held firms. A sharpabatement in taxes on large states and

a rise in the likely returns to politicalrent seeking accompany the resur-gence of pyramidal groups.

Goetzmann and Köll examinethe emergence of corporate ownershipin China from the final decades of theQing empire in the late 19th century tothe early Republican period in the1910s and 1920s. By analyzing theactual process of incorporation, thedevelopment of the legal and financialenvironment, and the role of the state,the authors ask whether the “top-down” approach — in which the cen-tral government established a legalframework for corporate enterprisebased on Western models — and theassumption that it would work as it didfor Western firms and markets was aviable approach to the modernizationof a financial system traditionally

dominated by family businesses andeconomic state patronage. Using busi-ness records from turn-of-the-centuryChinese corporations, they find that thegovernment’s “top-down” approach,only insufficiently promoted the systemof corporate capitalism. AlthoughChina’s first corporate code containedmany elements of the modern formu-la for privatization, it ultimately failedto effectively transform businessenterprise. The authors highlight tworeasons for the failure. First, the codedid not sufficiently shift ownershipand control from managers, previouslyempowered by government patronage,to shareholders. Second, the code wasineffective in stimulating the emer-gence of an active domestic share mar-ket that would induce family-ownedfirms and entrepreneurial managers to


exchange control for access to share-holder capital and the liquidity of anactive exchange.

Post-independent India pursued aset of economic policies that generallycurbed private sector activity and madeIndian industry fragmented anduncompetitive. The one exception tothis has been the Indian softwareindustry which began to grow in the1980s. Today the industry has morethan 2500 firms, all in the private sec-tor. The leading Indian software firmsare globally competitive, highly prof-itable, and are growing very rapidly.They are listed on the world’s majorstock exchanges, and boast of a largefraction of the world’s leading compa-nies as their customers. Khanna andPalepu trace the history of the devel-opment of the Indian software devel-opment, and the role played by the pri-vate sector product, labor, and finan-cial market intermediaries, and thedomestic business groups.

Murphy attempts to show thathistorical phenomena have had amajor impact in the determination ofFrance’s corporate ownership struc-ture. Corporate finance is generatedprincipally from three sources: banks,the capital market, and self-financing.If these are the three furrows leadingto corporate investment, then historyshows that two of them — the banksand the capital market — were subjectto considerable upheaval, renderingthem inoperable as channels for cor-porate finance for a long period inFrance’s corporate history. Faced withrestricted access to the banks and cap-ital markets, business entrepreneurshad to rely on self-financing as amethod of growing the business. Inturn, self-financing enabled theseentrepreneurs and their descendants toretain sizeable shareholdings in thefamily controlled business. Hence,from an historical perspective, it is notsurprising to see French families own-ing such a large proportion of Frenchcorporations. Furthermore, this styleof ownership ties in with the Frenchmentality that asset ownership is anintergenerational phenomenon. Theobjective of holding wealth is to passon to the next generation assets thathave risen in value. There are ofcourse other variables that help to

explain the high degree of concentra-tion of corporate ownership by fami-lies in France. One of the most impor-tant of these is the French approach tothe financing of pensions. Theabsence of funded pension schemeshas led to a far lower profile by pen-sion funds and assurance companies inthe French stock market: in 1997, pen-sion funds and assurance companiesconstituted 49 percent of householdsavings in the United Kingdom and 30percent in the United States asopposed to 18 percent in France.

Fohlin provides a wide-rangingdescription of German corporateownership and governance, both attheir roots in the nineteenth centuryand in more recent experience. Herdiscussion raises several particularlyimportant points: 1) Corporate gover-nance institutions — executive andsupervisory boards — remained quiteunderdeveloped in Germany until thelast quarter of the nineteenth century.Boards were generally small and grewlittle over the pre-war period. 2) Theuniversal banks were a significant butnot overwhelming presence in theownership and governance of Germancorporations during this period ofrapid heavy industrialization and eco-nomic expansion (roughly 1895-1912).Similarly, industrial firms played only asmall role in the ownership and gover-nance of other non-financial firms.(Notably, financial firms, especially thelarge banks, did own shares in otherbanks and subsidiaries and did sit onthe boards of those banks.) 3) Bankinvolvement in corporate ownershipappears to have arisen largely out ofthe banks’ active involvement withsecurities issues, particularly of listedfirms. Substantial holdings were rare,though earlier universal banks didsometimes unwillingly hold largestakes that they could not sell off for aperiod of time. 4) Bank involvement incorporate control through interlockingdirectorates is closely related to firms’size, sector securities issue, and stockmarket listing. Control rights appear tohave been granted largely via proxyvoting for customers who deposited(bearer) shares with the bank. 5) Thecombination of commercial, invest-ment, and brokerage services withinindividual banking institutions may

have facilitated the networking ofbank and firm supervisory boards. 6)Traditional explanations of Germanbank-firm relationships that focus onbanks’ intervention in investment deci-sions and direct monitoring of debtcontracts find little support in the cur-rent empirical analysis.

In the first half of the twentiethcentury, the U.K. capital markets weremarked by an absence of investor pro-tection; by the end of the century,there was more extensive protectionthere than virtually anywhere else inthe world. The United Kingdom there-fore provides an exceptional laborato-ry for evaluating how regulation affectsthe development of securities marketsand corporations. Franks, Mayer, andRossi investigate this issue by tracingthe ownership and board compositionof firms incorporated around 1900over the subsequent 100 years andcomparing the pattern of ownershipand control with a sample incorporat-ed around 1960. The authors findactive securities markets at the begin-ning of the century; firms were able toraise substantial outside equity financewith rapid dispersion of ownership,even in the absence of investor pro-tection. The introduction of investorprotection in the second half of thecentury was not associated withgreater dispersion of ownership butwith more trading in share blocks. Theauthors offer an explanation as to howU.K. capital markets could flourish inthe absence of investor protection.

Aganin and Volpin study theevolution of the stock market, thedynamics of the ownership structureof traded firms, the birth of pyramidalgroups, and the growth and decline offamilies in Italy. They use a uniquedataset covering all companies tradedon the Milan stock exchange duringthe twentieth century. The stock mar-ket evolved over time according to anon-monotonic pattern: it was relative-ly more developed at the beginningand at the end than in the middle ofthe century. Similarly, ownership struc-ture was more diffused in 1947 and in2000 than in 1987. Moreover, family-controlled groups and pyramids wereless common in 1947 and in 2000 thanin 1987. These findings are not consis-tent with the view that stock market


development and ownership concen-tration are a monotonic function ofinvestor protection.

Morck and Nakamura note thatJapan’s corporate sector began as zai-batsu family pyramids, was subjected toSoviet-style central planning, was reor-ganized into widely held firms, andfinally organized itself into keiretsu cor-porate groups. Both zaibatsu and keiret-su were probably rational responses toweak institutions, a talent shortage,abundant private benefits of control,and an environment where politicalrent seeking earns high returns. Othercommon justifications for corporategroups are at best of second-orderimportance. These include economiesof scope and scale and internal capitalallocation. The latter provides short-term benefits, but undermines thegroup in the longer term. Once domi-nant, such groups lobby for institu-tional reforms that further their domi-nance. Examples include the suppres-sion of the bond market in postwarJapan, managerial entrenchment inkeiretsu firms, and an increasing impor-tance of rent seeking as a source ofcompetitive advantage. This lobbyingalmost surely did not enhance socialwelfare.

Högfeldt explains that becauseof strong Social Democratic politicalinfluence since 1932, control of thelargest listed firms in Sweden hasremained firmly in the hands of a fewold families and banks via pyramidsand by extensive use of dual-classshares. A combination of wealth,inheritance, and capital gains taxeslocked capital into the established

firms, while heavy tax subsidization ofretained earnings and R and D spend-ing supported growth by stimulatinginvestments, often in very large proj-ects joint with the government.Addition of young fast-growing firmshas been very limited, because accu-mulation of private fortunes based onentrepreneurship and equity financingwas disfavored and treated at signifi-cant tax disadvantages for ideologicalreasons. Of the 50 largest listed firmstoday, 31 were founded before 1914,only eight in the post-war period, andnone after 1970. Being both control-ling owners and major providers ofloans to the largest listed firms, the twoleading banks acted more like long-term bondholders than risk-taking cap-italists. This fit the Social Democrats’vision of large-scale capitalist firms runin the interests of the firms’ stakehold-ers — social firms without owners — par-ticularly well. Taming of capitalism didnot mean immediate takeover of pri-vate ownership as long as the capital-ists invest and the export-oriented cor-porate sector remains efficient enoughto support a growing, tax-financedpublic sector with strong egalitarianambitions. Listed firms in effect didnot have to disperse ownership anddilute benefits of control in order toraise new capital, as their dependenceon equity markets was limited; on aver-age less than 1 percent of investmentsare financed by new issues. The histor-ical path of persistent social democrat-ic policies generated high growth ratesuntil the 1970s; then the negativeeffects of a stale, corporatist society con-trolled by political and economic powers

that have been heavily entrenched fordecades resulted in stagnation. The lackof economic and social dynamics ismanifest in the dominance of verylarge, old family-controlled firms, andby the over-sized public sector thatredistributes incomes, but not propertyrights, and wealth by encouraging out-siders to create new firms and fortunes.

A hundred years ago, Americancorporate control looked “normal”:large financial intermediaries and plu-tocratic families were controllingblockholders in the economy’s largeand growing Chandlerian enterprises.By 50 years ago, the United States hadbecome truly exceptional: blockhold-ing had become rare, and managerslargely autonomous. Roe (1994) arguesthat the political ethos of America wastoo hostile to the exercise of financierpower for blockholding intermediariesto survive. La Porta et al. (1999) paint apicture of blockholding around theworld as a response to weak protectionof minority shareholders, which sug-gests that American shareholders beenable to afford diversification becauseof the powerful and effectiveDelaware’s Chancery. Becht andDeLong say that the situation is morecomplicated. Yes, America’s deep equi-ty markets amplified the benefits ofdiversification. Yes, the DelawareChancery protects minority sharehold-er rights. Yes, there is a powerfulPopulist-Progressive current in Americanpolitics. But key historical accidentsplayed as large a role as the forcesadduced by Roe and La Porta et al. increating this form of American excep-tionalism.


Taxation and SavingAn NBER Conference on

Taxation and Saving, organized byJames M. Poterba of NBER andMIT, took place on August 1 and 2.The following papers were dis-cussed:

Andrew A. Samwick, NBER andDartmouth College, “Mutual FundChoice in 529 Plans: Federal TaxAdvantages and Local Monopolies”Discussant: Len Burman, UrbanInstitute

Susan Dynarski, NBER andHarvard University, “Who Benefitsfrom the Education SavingIncentives? Income, EducationalExpectations, and the Value of the529 and Coverdell”Discussant: Jeffrey Brown, NBERand University of Illinois

Gary Engelhardt, SyracuseUniversity, and Brigitte Madrian,NBER and University of Chicago,“Tax-Deferred Saving and

Participation in Employee StockPurchase Plans”Discussant: Roger H. Gordon,NBER and University of California,San Diego

Austan Goolsbee, NBER andUniversity of Chicago, “How DoTax Rates Affect Executives’Decisions About Corporate Stock?”Discussant: William M. Gentry,NBER and Columbia University

Wojciech Kopczuk, NBER andColumbia University, andEmmanuel Saez, NBER andUniversity of California, Berkeley,“Top Wealth Shares in the UnitedStates, 1916-2000: Evidence fromEstate Tax Returns”Discussant: Scott Weisbenner,NBER and University of Illinois

David Joulfaian, U.S. Departmentof the Treasury, and Kathleen M.McGarry, NBER and University ofCalifornia, Los Angeles, “Estate and

Gift Tax Incentives and Inter VivosGiving”Discussant: Alan J. Auerbach,NBER and University of California,Berkeley

Daniel R. Feenberg, NBER, andJames M. Poterba, “TheAlternative Minimum Tax andEffective Marginal Tax Rates”Discussant: Rosanne Altshuler,Rutgers University

Jagadeesh Gokhale, FederalReserve Bank of Cleveland, andLaurence J. Kotlikoff, NBER andBoston University, “The Impact onConsumption and Saving ofCurrent and Future Fiscal Policies”Discussant: Jonathan S. Skinner,NBER and Dartmouth College

James M. Poterba, “Valuing Assetsin Retirement Saving Accounts”Discussant: William Gale, BrookingsInstitution

The passage of tax reform legis-lation in 2001 opened up new tax-advantaged opportunities for familiesto save for college educations through529 plans. Unlike other tax-advantagedsavings accounts, 529 plans must bechartered by states. Several factors,including more favorable state incometax treatment of contributions or with-drawals, suggest the possibility of a“home bias” in which residents of astate tend to invest disproportionatelyin their own state’s plan. Home biasconfers a local monopoly rent on themutual fund family that manages the529 plans. Samwick analyzes theextent to which that rent appears in thefee structure and performance charac-teristics of mutual funds that are madeavailable in 529 plans. While examplescan be found of poor offerings in 529plans, the general result is that mutualfund companies do not systematicallyoffer higher fee, lower performingfunds to their captive market than totheir retail market.

Dynarski calculates the incen-tives created by the 529 and Coverdelltax-advantaged savings accounts(ESA) and studies how these incen-tives vary by income. She finds that theadvantages of the 529 and ESA risesharply with income, for three reasons.First, those with the highest marginaltax rates benefit the most from shel-tering income, gaining in both absoluteand relative terms. Second, theaccounts are risky for families whosechildren may not attend college,because account holders are penalizedif the accounts are not used forschooling. Dynarski calculates the min-imum probabilities of college atten-dance that are required for the 529 andESA to have expected returns at leastas high as alternative saving vehicles.She finds that, for households withincomes below $57,000, these break-even probabilities are higher than theobserved rates at which their childrengo to college. Third, the financial aidsystem reduces aid disproportionately

for those families that hold their assetsin the 529 or ESA rather than in con-ventional saving vehicles. The financialaid “tax” is particularly high for theESA; for families on the margin ofreceiving need-based financial aid,ESA returns net of income and aidtaxes are negative. Since the highest-income families are not affected by theaid tax, this further intensifies the pos-itive correlation between income andthe advantages of the tax-advantagedcollege savings accounts.

Employee stock purchase plans(ESPPs) are designed to promoteemployee stock ownership in the firmand to provide another tax-deferredvehicle for capital accumulation, alongwith traditional pensions and 401(k)s.Englehardt and Madrian analyze theincentives that employees face to par-ticipate in an ESPP, and find that401(k) saving with employer matchingcontributions dominates ESPP savingfor retirement on an after-tax basis forall but the shortest horizons. Then the


authors empirically examine ESPPparticipation using administrative datafrom 1997-2001 for a large healthservices company that employs over30,000 people. The picture thatemerges suggests that participation inand contributions to the ESPP are rel-atively large in magnitude, and the401(k) and ESPP plans do not com-pete for the first dollar of employer-based plan saving. Rather, employeestend to exhaust saving opportunities inthe 401(k) first, and then to contributemarginal saving to the ESPP. However,employees appear to be backward-looking when forecasting futurereturns and making company stockpurchase commitments. This suggeststhat employees may not be fully awareof the risk of company stock and thebenefits of diversification. Taxes donot seem to be a prime determinant ofESPP participation.

Goolsbee uses data on executivecompensation during 1992-2000,matched to information on federal andstate marginal tax rates on differenttypes of income, to examine theimpact of taxes on executives’ deci-sions about corporate stock. He showsthat lower capital gains taxes corre-spond to executives significantlyincreasing their holding of corporatestock. He then illustrates how interac-tions between ordinary income taxes,capital gains taxes, and corporateincome taxes interact in the executives’decision on whether to exercise theirstock options early. When capital gainstaxes fall, as in 1997, executives havean incentive to exercise early and topay taxes on part of the gain at ordi-nary income rates now in order to getfuture appreciation of the stock taxedat the lower capital gains rates in thefuture. The estimates confirm themodel, and suggest that executives dohave some inside information into thefuture prospects of the company,because firms whose stocks ends upgrowing faster are more likely to exer-cise early. Interestingly, the executivesappear to place almost no weight onthe corporate tax consequences oftheir exercise decisions, because thecorporate income tax rate facing theircompanies has no influence on theirbehavior.

Using estate tax return data,

Kopczuk and Saez present newhomogeneous series on top wealthshares from 1916 to 2000 in theUnited States. Top wealth shares werevery high at the beginning of the peri-od but have been hit sharply by theGreat Depression, the New Deal, andWorld War II shocks. Those shockshave had permanent effects. Followinga decline in the 1970s, top wealthshares recovered in the early 1980s, butthey are still much lower in 2000 thanin the early decades of the century.Most of the changes the authors doc-ument are concentrated among thevery top wealth holders, with muchsmaller movements for groups belowthe top 0.1 percent. Consistent withthe Survey of Consumer Financesresults, top wealth shares estimatedfrom estate tax returns display no sig-nificant increase since 1995. Evidencefrom the Forbes 400 richest Americanssuggests that only the super-rich haveexperienced significant gains relativeto the average over the last decade.The most plausible explanations forthe facts have been the developmentof progressive income and estate taxa-tion, which has dramatically impairedthe ability of large wealth holders tomaintain their fortunes, and thedemocratization of stock ownership,which now spreads stock market gainsand losses much more widely than inthe past.

A very small but growing body ofthe literature has examined the patternof lifetime gifts. Some of these studiesrelied on cross-sectional survey andadministrative records; others haveemployed aggregate time-series dataon gifts. However, little is knownabout the pattern of giving during thelife cycle. For instance, two questionshave yet to be explored: how gifts areallocated over life and how frequentlygifts are made. This may be deter-mined by wealth and age, but taxes alsomay play an important role. To addressthese questions, and to explore the roleof taxes, Joulfaian and McGarry usetwo datasets. The first consists of sev-eral waves of the HRS/AHEAD sur-vey, and the second uses longitudinaldata on gifts from gift tax returns thatare linked to estate tax returns. Theadministrative records are particularlyuseful in studying giving patterns of

the wealthy, but not in the case of theless wealthy, where the survey data hasa comparative advantage. The findingssuggest that much of the giving takesplace late in life. While these findingsalso suggest that taxes are an impor-tant consideration in the timing oftransfers of the rich, this timing is notuniversally consistent with a tax mini-mization strategy.

Feenberg and Poterba examinethe impact of the Alternative MinimumTax on the weighted average marginaltax rates that apply to various compo-nents of taxable income. They alsoconsider the impact of various AMTreform proposals on the number ofAMT taxpayers and the total revenuecollected from the AMT over the nextdecade. Using the NBER TAXSIMmodel to project federal personalincome tax liabilities and AMT liabili-ties between 2003 and 2013, theauthors’ projections show that modestincreases in the AMT exclusion levelhave substantial effects on the numberof AMT taxpayers. Further, indexingthe AMT parameters would reduce thenumber of households with AMT lia-bility from 36 million to 14 million in2010. The presence of the AMT hasonly a modest impact on the averagemarginal tax rates on most incomeflows because some AMT taxpayersface higher marginal tax rates and oth-ers lower tax rates as a result of the tax.

Gokhale and Kotlikoff investi-gate the potential impact of alternativefiscal policies on current consumptionand saving. Their analysis uses house-holds drawn from the FederalReserve’s 1995 Survey of ConsumerFinances. This dataset providesdetailed information on householdearnings, assets, housing, demograph-ics, and retirement plans. The policiesthe authors consider are: tax hikes, taxcuts, Social Security benefit cuts, andthe elimination of tax-deferred saving.The results are influenced by the factthat a significant minority of theirsample is liquidity-constrained, andthus more responsive to current thanto future policy changes, no matterhow long their duration. The resultsalso are very sensitive to the particularpolicy being enacted. Income taxchanges, for example, have little effecton the consumption/saving of low-


income households for the simple rea-son that their income tax liabilities arerelatively small. And, Social Securitybenefit cuts have only minor effects onthe young, because they will occur sofar in the future, and because theyoung generally are liquidity con-strained. One the other hand, eliminat-ing tax-deferred saving will have noeffect on current retirees, but greatlyinfluences the spending of the young,since such a policy would relax theirliquidity constraints. Each of the poli-cies considered has a quite sizeableeffect on the current consumption andsaving behavior of a substantial subsetof this sample, though.

Assets in retirement saving planshave become an important componentof net worth for many households.While many studies compare house-hold balances in tax-deferred retire-ment accounts such as 401(k) plans

with the amount held in other financialassets outside these accounts, thesedifferent asset components are notdirectly comparable. Taxes, and insome cases penalties, are due whenassets are withdrawn from retirementsaving plans. These factors can makeassets inside retirement accounts lessvaluable than assets outside theseaccounts, particularly for those whoare considering withdrawing assetsfrom the tax-deferred accounts in thenear future. For younger householdswho do not plan to withdraw taxdeferred assets for many years, there isa countervailing factor — the opportu-nity for tax-free compound returns inretirement accounts — that can makeassets in such accounts more valuablethan similar assets outside suchaccounts. For a long-horizon retire-ment saver, a dollar inside a tax-deferred retirement saving account

may be more valuable than a dollaroutside such an account, even thoughthe payouts of principal from theretirement account will be taxed at thetime of distribution while the principaloutside such accounts is untaxed.Poterba illustrates the potential differ-ences in the value of assets inside andoutside tax-deferred accounts. Hedraws on a range of data sources tocalibrate the value of the tax burden,and the benefit of compound growth,for assets held in retirement accounts,and describes the differences in rela-tive valuation for households of differ-ent ages.

These papers will be published ina forthcoming issue of the NationalTax Journal. They will also be availableat “Books in Progress” on the NBER’swebsite.

*


Japan ConferenceThe NBER, Centre for

Economic Policy Research (CEPR),Center for International Reseach onthe Japanese Economy (CIRJE), andEuropean Institute of JapaneseStudies (EIJS) jointly organized aconference on the Japanese economyin Tokyo on September 19-20. Theco-chairs of the meeting were:Magnus Blomstrom, NBER andStockholm School of Economics;Jennifer Corbett, Australian NationalUnion; Fumio Hayashi, NBER andthe University of Tokyo; Anil KKashyap, NBER and the GraduateSchool of Business, University ofChicago; and David Weinstein,NBER and Columbia University. Thefollowing papers were discussed:

Alan J. Auerbach and MauriceObstfeld, NBER and University ofCalifornia, Berkeley, “The Case forOpen-Market Purchases in aLiquidity Trap”Discussant: Susanto Basu, NBERand University of Michigan

Gunter Coenen and VolkerWieland, European Central Bank,

“The Zero-Interest-Rate Bound andthe Role of the Exchange Rate forMonetary Policy in Japan”Discussant: David Gruen, AustralianDepartment of the Treasury

I. Serdar Dinc, University ofMichigan, and Patrick M.McGuire, Bank for InternationalSettlements, “Did Investors RegardReal Estate as ‘Safe’ during the‘Japanese Bubble’ in the 1980s?”Discussant: Kenneth J. Singleton,NBER and Stanford University

Ricardo J. Caballero, NBER andMIT; Takeo Hoshi, NBER andUniversity of California, San Diego;and Anil K Kashyap, “ZombieLending and DepressedRestructuring in Japan”Discussant: Chang-Tai Hsieh,NBER and Princeton University

Robert Dekle, University ofSouthern California, and KennethKletzer, University of California,Santa Cruz, “The Japanese BankingCrisis and Economic Growth:Theoretical and Empirical

Implications of Deposit Guaranteesand Weak Financial Regulation”Discussant: David Smith, FederalReserve Board

Tetsuji Okazaki, University ofTokyo, and Michiru Sawada,Hitotsubashi University, “BankMerger Movement and Evolution ofFinancial System: Experiences inPrewar Japan”Discussant: Takeo Hoshi

Yoshiro Miwa, University ofTokyo, and J. Mark Ramseyer,Harvard University, “Who AppointsThem, What Do They Do?Evidence on Outside Directorsfrom Japan”Discussant: Randall Morck, NBERand University of Alberta

Gauti Eggertsson, InternationalMonetary Fund, and MichaelWoodford, NBER and PrincetonUniversity, “Optimal MonetaryPolicy in a Liquidity Trap”Discussant: Kazuo Ueda, Bank ofJapan

The prevalent thinking about liq-uidity traps suggests that the perfectsubstitutability of money and bonds ata zero short-term nominal interest raterenders open market operations inef-fective for achieving macroeconomicstabilization goals. Auerbach andObstfeld show that even if this werethe case, there would remain a power-ful argument for large-scale open mar-ket operations as a fiscal policy tool.This same reasoning implies that openmarket operations will be beneficial forstabilization as well, even when theeconomy is expected to remain miredin a liquidity trap for some time. Thus,the microeconomic fiscal benefits ofopen market operations in a liquiditytrap go hand in hand with standardmacroeconomic objectives. Motivatedby Japan’s recent economic experience,the authors use a dynamic general-equilibrium model to assess the wel-

fare impact of open market operationsfor an economy in Japan’s predica-ment. They argue that Japan canachieve a substantial welfare improve-ment through large open market pur-chases of domestic government debt.

Coenen and Wieland study therole of the exchange rate in conduct-ing monetary policy in an economywith near-zero nominal interest ratesas Japan has experienced since themid-1990s. This analysis is based on anestimated model of Japan, the UnitedStates, and the euro area with rationalexpectations and nominal rigidities. Teauthors first provide a quantitativeanalysis of the impact of the zerobound on the effectiveness of interestrate policy in Japan in terms of stabi-lizing output and inflation. Then theyevaluate three concrete proposals thatfocus on depreciation of the currencyas a way to ameliorate the effect of the

zero bound and to evade a potentialliquidity trap. Finally, they investigatethe international consequences ofthese proposals.

It is well known that Japanesebanks increased their exposure to landassets and the real estate sector in thelatter half of the 1980s, and that thisbecame a primary factor in the non-performing loan problem that emergedin the 1990s. What is less clear, howev-er, is whether this increased exposurewas the result of active risk taking, andwhether banks and other market par-ticipants regarded land and real estateassets as “risky” while real estate priceswere increasing dramatically. Toaddress this issue, Dinc and McGuirerely on real estate data contained incorporate balance sheets to estimatethe market sentiment toward landassets during 1985-9. They find thatthe systemic risk of manufacturing


companies increased with their realestate holdings but not with other bal-ance sheet assets. This indicates thatmarket participants regarded realestate holdings as riskier than the mainoperations of manufacturing compa-nies during the “bubble period,” evenif they may not have foreseen the sub-sequent crash in real estate prices.

Caballero, Hoshi, and Kashyappropose a bank-based explanation forthe decade-long Japanese slowdown.They start with the well-known obser-vation that most large Japanese bankswould be out of business if regulatorsforced them to recognize all their loanlosses immediately. Because of this, thebanks keep many “zombie firms” aliveby “evergreening” their loans: rollingover loans that they know will not becollected. Thus, the normal competi-tive outcome, whereby the zombieswould shed workers and lose marketshare, is being thwarted. The authorshighlight the restructuring implicationsof this zombie problem: the counter-part of the congestion created by thezombies is a reduction of the profitsfor potential new and more productiveentrants, which discourages their entry.In this context, even solvent banks seeno particularly good lending opportu-nities in Japan. Essentially Japan hasreached the situation of having bank-rupt banks lend to bankrupt firms, andin this scenario the private sector strug-gles. The authors confirm their keypredictions that zombie-dominatedindustries exhibit more depressed jobcreation, lower productivity, andgreater excess capacity.

Dekle and Kletzer use an endo-geneous growth model with financialintermediation to show how govern-ment policies towards the financial sec-tor can lead to banking crises and per-sistent growth slumps. The modelshows how government deposit guar-antees and regulatory forbearance canlead to permanent declines in the

growth rate of the economy. Theeffects of inadequate prudential super-vision on asset price dynamics underperfect foresight also are derived in themodel. The policies that are used in theanalysis are based on essential featuresof Japanese financial regulation. Theimplications of the model then arecompared to the experience of theJapanese economy and financial systemduring the 1990s. The authors find thatthe dynamics predicted by their modelare generally consistent with the recentbehavior of economic aggregates, assetprices, and the banking system forJapan. One policy implication of themodel is that the impact on future eco-nomic growth depends on the lengthof time the government fails to enforceloan-loss reserving by banks.

Okazaki and Sawada examinethe effects of bank consolidations onthe financial system, using data on theJapanese banking industry before theSecond World War, when the firstbank merger movement occurred anddeposit insurance did not exist. Thefocus of their analysis is governancestructure and the performance ofbanks. The authors find that consoli-dations had the effect of excluding anunfavorable interlocking directoratebetween banks and their related firms,especially in the case of absorbingconsolidations. The authors also con-firm that consolidations had a positiveeffect on deposit growth, but not onbank profitability.

Miwa and Ramseyer assembledata on the 1,000 largest exchange-list-ed Japanese firms from 1986-94 andexplore which firms tend to appointoutsiders to their boards. They findthat appointments are decidedly non-random. Firms appoint directors fromthe banking industry when they bor-row heavily, when the firm has fewermortgageable assets, or when the firmitself is in the service and financeindustry. Firms appoint retired govern-

ment bureaucrats when they are inconstruction and sell a large fraction oftheir output to government agencies.And, firms appoint other retired busi-ness executives when they have a dom-inant parent corporation or when theyare in the construction industry andsell heavily to the private sector. Theauthors then ask whether firms withmore outside directors outperformthose with fewer. They find that theydo not. Instead, as the logic of marketcompetition predicts, board composi-tion seems endogenous. Given that thecomposition does not change fromthe thriving 1980s to the depressed1990s, optimal board structure seemsnot to depend on the macroeconomicenvironment.

Eggertsson and Woodford con-sider the consequences for monetarypolicy of the zero floor for nominalinterest rates. The zero bound can be asignificant constraint on the ability ofa central bank to combat deflation.The authors show, in the context of anintertemporal equilibrium model, thatopen market operations, even “uncon-ventional” ones, are not effective ifthey do not change expectations aboutthe future conduct of policy.Nonetheless, a credible commitmentto the right sort of history-dependentpolicy can largely mitigate the distor-tions created by the zero bound. Inthis model, optimal policy involves acommitment to adjust interest rates soas to achieve a time-varying price-leveltarget when it is consistent with thezero bound. The authors also discussways in which other central bankactions, while irrelevant apart fromtheir effects on expectations, may helpto make a central bank’s commitmentto its target credible. They also consid-er implications for the policy optionscurrently available for overcomingdeflation in Japan.


Bureau News

Rajan Heading to the IMFNBER Research Associate

Raghuram G. Rajan, who directs theNBER’s Program on CorporateFinance, has been appointed EconomicCounsellor and Director of theResearch Department at theInternational Monetary Fund. He willsucceed another NBER researcher,

Kenneth S. Rogoff, who returned toHarvard University’s EconomicsDepartment in September.

Rajan is also the Joseph L. GidwitzProfessor of Finance at the Universityof Chicago Graduate School ofBusiness. He has taught at MIT,Northwestern University, and the

Stockholm School of Economics, andbeen a consultant to the FederalReserve Board, the World Bank, andthe IMF. Other NBER researchers whohave served in the same capacity at theIMF include Jacob A. Frenkel andMichael L. Mussa.

Jolls to Co-Direct NBER’s Program on Law and EconomicsChristine Jolls, an NBER Research

Associate and Professor of Law at HarvardLaw School (HLS), is joining her Harvard col-league Steven Shavell as co-director of theNBER’s Program of Research on Law andEconomics. Jolls holds a B.A. from StanfordUniversity, a J.D. from Harvard Law School,

and a Ph.D. in economics from MIT. Beforejoining the HLS faculty, she clerked for JudgeStephen F. Williams on the U.S. Court ofAppeals for the D.C. Circuit in 1995-6 and forJustice Antonin Scalia of the U.S. SupremeCourt in 1996-7.

New Directors Elected by NBER BoardAt its annual meeting in September,

the NBER's Board of Directors electedfive new directors. The newest at-largeNBER Board member is Jessica P.Einhorn. She is Dean of the Paul H.Nitze School of Advanced InternationalStudies at Johns Hopkins University.

Richard B. Berner, ManagingDirector and Chief U.S. Economist forMorgan Stanley Global EconomicResearch, replaces Richard D. Rippe as

the representative of the NationalAssociation for Business Economics.Professor Ray C. Fair replaces WilliamBrainard as Yale University's represen-tative on the NBER's Board ofDirectors. Thea Lee, Assistant Directorof Public Policy for the AFL-CIO(American Federation of Labor andCongress of Industrial Organizations),will replace David Smith as the repre-sentative from the AFL-CIO. Jeffrey M.

Perloff, a member of the Departmentof Agricultural and Research Eco-nomics at the University of California,Berkeley, will replace Mark Drabenstottas the NBER's representative from theAmerican Agricultural EconomicsAssociation.

These new Board members will beprofiled in future issues of the NBERReporter.


Economic Fluctuations and GrowthThe NBER’s Program on

Economic Fluctuations and Growthmet in Cambridge on July 19.Organizers Andrew Abel, NBERand University of Pennsylvania, andValerie Ramey, NBER andUniversity of California, San Diego,chose these papers for discussion:

Laura L. Veldkamp, INSEAD,“Media Frenzies in Markets forFinancial Information”Discussant: John V. Leahy, NBERand New York University

Markus K. Brunnermeier,Princeton University, and JonathanA. Parker, NBER and Princeton

University, “Optimal Expectations”Discussant: David Laibson, NBERand Harvard University

Fatih Guvenen, University ofRochester, “A ParsimoniousMacroeconomic Model for AssetPricing: Habit Formation or Cross-Sectional Heterogeneity?”Discussant: John Y. Campbell,NBER and Harvard University

Change-Tai Hsieh, NBER andPrinceton University, and Peter J.Klenow, Federal Reserve Bank ofMinneapolis, “Relative Prices andRelative Prosperity,” (NBERWorking Paper No. 9701)

Discussant: Samuel S. Kortum,NBER and University of Minnesota

Robert E. Hall, NBER andStanford University, “WageDetermination and EmploymentFluctuations”Discussant: Garey Ramey,University of California, San Diego

Olivier J. Blanchard, NBER andMIT, and Thomas Philippon,MIT, “The Decline of Rents, andthe Rise and Fall of EuropeanUnemployment”Discussant: Jordi Gali, NBER andCREI

Promising emerging equity mar-kets often witness investment herdsand frenzies, accompanied by an abun-dance of media coverage. Comple-mentarity in information acquisitioncan explain these anomalies. Becauseinformation has a high fixed cost ofproduction, its equilibrium price is lowwhen its quantity is high. Investors allbuy the most popular informationbecause it has the lowest price. Giventwo identical asset markets, investorsherd: asset demand is higher in themarket with abundant informationbecause information reduces risk. Bylowering risk, information raises theasset’s price. Transitions between low-information/low-asset-price and high-information/high-asset-price equilibri-

ums raise price volatility and createprice paths resembling periodic fren-zies. Using equity data and a new paneldata set of news counts for 23 emerg-ing markets, Veldkamp shows thatwhen asset market volatility increases,news coverage intensifies, and thatmore news is correlated with higherasset prices.

Brunnermeier and Parker intro-duce a tractable structural model ofsubjective beliefs. Forward-lookingagents care about expected future util-ity flows, and hence are happier now ifthey believe that better outcomes aremore likely. On the other hand, expec-tations that are biased towards opti-mism worsen decisionmaking, leadingto poorer realized outcomes on aver-

age. Optimal expectations balancethese forces by maximizing the lifetimewell-being of an agent. The authorsapply their optimal expectationsframework to three different econom-ic settings. In a portfolio choice prob-lem, agents overestimate the return ontheir investment and may invest in anasset with negative expected excessreturn if sufficiently positively skewed.In general equilibrium, agents’ priorbeliefs are endogenously heteroge-neous, leading to gambling. Finally, in aconsumption-saving problem with sto-chastic income, agents are both over-confident and overoptimistic, and con-sume more than implied by rationalbeliefs early in life.

Guvenen studies the asset pricing

Twenty-fourth NBER Summer Institute Held in 2003In the summer of 2003, the NBER

held its twenty-fourth annual SummerInstitute. More than 1200 economistsfrom universities and organizationsthroughout the world attended. The

papers presented at dozens of differentsessions during the four-week SummerInstitute covered a wide variety of top-ics. A complete agenda and many ofthe papers presented at the various ses-

sions are available on the NBER’s website by clicking Summer Institute 2003on our conference page, found at:www.nber.org/confer.


implications of a parsimonious two-agent macroeconomic model with twokey features: limited participation inthe stock market and heterogeneity inthe elasticity of intertemporal substitu-tion. The parameter values for themodel are taken from the businesscycle literature and are not calibratedto match any financial statistic. Yet,with a risk aversion of two, the modelis able to explain a large number ofasset pricing phenomena, including: ahigh equity premium and a low risk-free rate; a counter-cyclical risk premi-um, volatility, and Sharpe ratio; pre-dictable stock returns with coefficientsand R2 values of long-horizon regres-sions matching their empirical coun-terparts, among others. In addition themodel generates a risk-free rate withlow volatility (5.7 percent annually)and with high persistence. Guvenenalso shows that the similarity of herresults to those from an external habitmodel is not a coincidence: the modelhas a reduced form representationwhich is remarkably similar toCampbell and Cochrane’s frameworkfor asset pricing. However, the macroeco-nomic implications of the two models arequite different, favoring the limitedparticipation model. Moreover, sheshows that policy analysis yields dra-matically different conclusions in eachframework.

The positive correlation betweenpurchasing power parity (PPP) invest-ment rates and PPP income levels

across countries is one of the mostrobust findings of the empiricalgrowth literature. Hsieh and Klenowshow that this relationship is drivenalmost entirely by differences in theprice of investment relative to outputacross countries. When measured atdomestic prices rather than at interna-tional prices, investment rates are bare-ly correlated with PPP incomes. Theauthors find that the high relative priceof investment in poor countries isattributable solely to the low price ofconsumption goods in poor countries.Investment prices are no higher in poorcountries than in rich countries. Thesefacts suggest that the low PPP invest-ment rates in poor countries are notcaused by low savings rates or by hightax or tariff rates on investment.Instead, poor countries appear to beplagued by low efficiency in producinginvestment goods and in producingexportables to trade for machinery andequipment.

After a recession, the aggregatelabor market is slack: employmentremains below normal and recruitingefforts of employers, as measured byvacancies, are low. A model of match-ing frictions explains the qualitativeresponses of the labor market toadverse shocks, but requires implausi-bly large shocks to account for themagnitude of observed fluctuations.The incorporation of wage-settingfrictions vastly increases the sensitivityof the model to driving forces. Hall

develops a new model of wage friction.The friction arises in an economicequilibrium and satisfies the conditionthat no market participant has an unex-ploited opportunity for unilateralimprovement. The wage friction neitherinterferes with the efficient formation ofemployment matches nor causes ineffi-cient job loss. Thus it provides ananswer to the fundamental criticismpreviously directed at sticky-wagemodels of fluctuations.

Blanchard and Philippon devel-op three propositions: 1) Higher prod-uct and capital market competition andintegration since the 1970s have led toa steady decline in rents and to smallerand briefer quasi-rents. 2) Thesechanges are likely to increase efficiencyand output in the long run, but it maytake time for economic actors to fullyunderstand them and to adapt. In thepresence of collective bargaining andslow learning by unions, these changescan generate first a rise and then adecline in unemployment. This fits thegeneral evolution of unemployment inEurope since the 1970s. 3) The speedof learning by unions is likely todepend on the degree of trust betweenlabor and capital. The empirical evi-dence suggests that differences in trustcan explain much of the difference inthe evolution of unemployment acrosscountries. Countries with lower trusthave had more of an increase, and alater turnaround, in unemployment.

*


The Chinese EconomyThe NBER’s Working Group

on the Chinese Economy, organizedby Shang-Jin Wei, NBER andInternational Monetary Fund, met inCambridge on October 3. The par-ticipants in this first meeting of theworking group included NBERResearch Associates and FacultyResearch Fellows who had partici-pated in a joint NBER-CCER(China Center for EconomicResearch) meeting in Beijing, plus anumber of experts on the Chineseeconomy who teach at Americanuniversities. The formal meeting waspreceded by a dinner at whichProfessor Dwight Perkins ofHarvard spoke about current issuesfacing the Chinese economy. Themeeting program was:

Robert C. Feenstra, NBER andUniversity of California, Davis, and

Gordon H. Hanson, NBER andUniversity of California, San Diego,“Ownership and Control inInternational Outsourcing:Estimating the Property-RightsTheory of the Firm”Discussant: Chenggang Xu, LondonSchool of Economics

Chun-Chung Au, BrownUniversity, and J. VernonHenderson, NBER and BrownUniversity, “Estimating Net UrbanAgglomeration Economies with anApplication to China”Discussant: Mary Amiti,International Monetary Fund

Genevieve Boyreau-Debray,World Bank, and Shang-Jin Wei,“Can China Grow Faster? ADiagnosis on the Fragmentation ofthe Domestic Capital Market”

Discussant: Chun Chang, Universityof Minnesota

Hehui Jin and Barry R. Weingast,Stanford University, and YingyiQian, University of California,Berkeley, “Federalism, Chinese StyleI: Fiscal Incentives and RegionalDevelopment” and“Federalism and Chinese Style II:Economic Decentralization andPolitical Centralization”Discussant: Barry Naughton,University of California, San Diego

Wei Li, University of Virginia,“Measuring Corruption underChina’s Dual-Track System”Discussant: Loren Brandt,University of Toronto

Feenstra and Hanson develop asimple model of international out-sourcing and apply it to processingtrade in China. They observe China’sprocessing exports, broken down bywho owns the plant and by who controls theinputs that the plant uses. Multinationalfirms engaged in export processing inChina tend to split factory ownershipand input control with managers inChina: the most common outcome isto have foreign factory ownership butChinese control over the inputs. Toaccount for this organizationalarrangement, the authors appeal to aproperty-rights model of the firm.Multinational firms and the Chinesefactory managers with whom theycontract divide the surplus associatedwith export processing by Nash bar-gaining. Threat-point payoffs are sub-ject to a loss in human capital. In theirbenchmark estimates, this loss inhuman capital is estimated at 33-40percent in all provinces except thesouthern coast, but only about 22 per-cent in Fujian, Guangdong, andHainan. The probability of legalenforcement of contracts has a similarpattern and is lowest in the southern

coastal provinces and highest inBeijing.

Au and Henderson model andestimate net urban agglomerationeconomies for cities. Economic mod-els of cities postulate an inverted-Ushape of real income per workeragainst city employment, where theinverted-U shifts with industrial com-position across the urban hierarchy ofcities. This relationship has never beenestimated, in part because of datarequirements. China has the necessarydata and context. The authors find thatthe benefits of urban agglomeration arehigh: real incomes per worker risesharply with increases in city size froma low level. They level out nearer thepeak, but then decline very slowly pastthe peak. Au and Henderson find that alarge fraction of cities in China areundersized, because of strong migra-tion restrictions, and they find largeincome losses from these restrictions.

Boyreau-Debray and Wei lookat the financial side of Chinese eco-nomic development. One seriousdrawback of the Chinese financial sys-tem (beyond the bad-loans problem inits banking sector) may be the segmen-

tation of the internal capital market,but it has not received much researchattention. This paper fills the void,using two standard tools from interna-tional finance to analyze internal finan-cial integration across 28 Chineseprovinces from 1978-2000. The firsttest, proposed by Feldstein andHorioka (1980) and modified in thesubsequent literature, examines thecorrelation between local investmentand local saving. The second test,drawn from the risk-sharing literature,uses consumption data to evaluatefinancial integration. Both tests con-firm a similar (and somewhat surpris-ing) picture: capital mobility withinChina is low! More precisely, it is muchlower than within financially integratedcountries, such as Japan or the UnitedStates. In fact, the degree of inter-provincial capital mobility withinChina is similar to the level observedacross national borders among theOECD countries. Furthermore, thedegree of internal financial integrationappears to have decreased significantly,rather than increased, in the 1990s rel-ative to the earlier period. Finally, theauthors document that the govern-


ment (as opposed to the private sector)tends to systematically re-allocate capi-tal from more productive regions toless productive ones. In this sense, asmaller role for the government in thefinancial sector might increase thegrowth rate of the economy.

The theory of market-preservingfederalism stresses the importance offiscal decentralization and the incen-tives of government on market devel-opment. Using a panel dataset fromChina, Jin, Quian, and Weingastinvestigate the changing fiscal relation-ship between the central and provincialgovernments before and after reform.They first find a much higher correla-tion, about four times, between theprovincial government’s budgetaryrevenue collection and its budgetaryexpenditure after the reform thanbefore the reform. This is evidence ofmuch stronger ex post fiscal incentivesfor provincial governments. Theauthors also find that stronger ex antefiscal incentives, measured by the con-tractual marginal retention rate of the

provincial government in its budgetaryrevenue collection, imply faster devel-opment of the provincial economy.This is evidence of the impact of fis-cal incentives on regional develop-ment. Finally, the authors comparefederalism, Chinese style, to federal-ism, Russian style.

In a second and related paper,these authors use a panel dataset toinvestigate the central-provincial rela-tionship during China’s reform. Herethe two major empirical findings are:first, greater fiscal decentralization andstronger fiscal incentives — the lattermeasured in terms of higher (ex ante)provincial marginal revenue retentionrate — imply faster development ofnon-state enterprises and more reformin state-owned enterprises in theprovince. Second, the political controlof the central government, throughthe Communist Party, over provincialofficials’ appointment has the oppositeeffect, but does restrict the provincialgovernment’s excess investment. It isnot as effective in curbing excess cred-

it expansion, also a concern of thecentral government at the time.

Li presents statistical evidence ofthe pervasiveness of official diversionin China’s industrial planning bureau-cracy under the dual-track system. Theunderpricing of in-plan goods andtheir ensuing shortage has led to gainsfrom trade between officials who con-trolled the allocation of in-plan goodsand customers willing to pay morethan the plan prices. By divertinggoods from the plan and resellingthem at higher market prices, this cor-ruption creates leaks in the plan. Usingdata from a survey of state-ownedmanufacturers supplemented by aggre-gate input-output data, Li finds that theleakage in the plan, which measures thesize of official diversion, became statis-tically detectable after the introductionof the dual-track system in 1985 andincreased sharply in the late 1980s.Estimates show that approximatelyone-third of all in-plan industrial out-put was diverted between 1987 and1989.

*


Bureau Books

Tax Policy and the Economy, Volume17, edited by James M. Poterba, isavailable from the MIT Press for$25.00 in paperback and $58.00 cloth-bound. This NBER series presentscurrent NBER research in the areas oftaxation and government spending.

Volume 17 continues the series’ tradi-tion of addressing topics that are ofcurrent relevance as well as longer-range concerns. The topics coveredinclude the fiscal implications of theNo Child Left Behind Act, the 2001Tax Rebate, and the tax burdens of

multinational corporations.Poterba directs the NBER’s

Program on Public Economics and isthe Mitsui Professor of Economicsand the Associate Head of theEconomics Department at MIT.

NBER Macroeconomics Annual 2002,edited by Mark Gertler and Kenneth S.Rogoff, is available from the MITPress for $32.00 in paperback and$65.00 clothbound. The NBERMacroeconomics Annual presents,extends, and applies pioneering workin macroeconomics and stimulateswork by macroeconomists on impor-

tant policy issues. Each paper in theAnnual is followed by comments anddiscussion.

This volume includes papers on:rules versus discretion in monetarypolicy; productivity growth in the cur-rent century; an examination ofwhether the business cycle haschanged; and a discussion of optimal

currency areas.Gertler and Rogoff are NBER

Research Associates in the Programs onMonetary Economics and InternationalFinance and Macroeconomics, respec-tively. Gertler is a professor of eco-nomics at New York University; Rogoffis a professor of economics at HarvardUniversity.

Structural Impediments to Growth inJapan, edited by Magnus Blomström,Jennifer Corbett, Fumio Hayashi, andAnil K Kashyap, is available this fallfrom the University of Chicago Pressfor $70.00.

As the much-lauded “miracle” ofJapan’s stunning economic growth hasgiven way to economic stagnation, ana-lysts have focused their attention on theunderlying systems that present obsta-cles to continued success. In a firstbook-length academic treatment of thisimportant issue, a team of notable edi-tors and contributors gathers to present

nine papers offering a comprehensiveassessment of those economic difficul-ties. The topics covered range fromfinancial problems to corporate issuesto issues in government policy. Theresult is an invaluable collection ofinformation on the key challenges fac-ing continued economic growth.

All of the volume’s editors aremembers of the NBER’s JapanProject. Blomström is a professor atthe European Institute of JapaneseStudies and the Stockholm School ofEconomics. Corbett is a reader at the University of Oxford and professor at

Australian National University.Hayashi is a professor in the faculty ofeconomics at the University of Tokyo.Kashyap is the Edward Eagle BrownProfessor of Economics and Financein the Graduate School of Business atthe University of Chicago.

To order from the University ofChicago Press, write to ChicagoDistribution Center, 11030 SouthLangley, Chicago, IL 60628. Or tele-phone: 1-800-621-2736 (from the U.S.and Canada); or (773) 568-1550 (fromthe rest of the world). Email orders to:[email protected].

Tax Policy and the Economy, Volume 17

NBER Macroeconomics Annual 2002

Structural Impediments to Growth in Japan

The following two volumes may be ordered from the MIT Press, c/o Triliteral, 100 Maple Ridge Drive, Cumberland, RI02864. To order by phone: TOLL FREE in the US and Canada: 1-800-405-1619 (9 am - 5 pm EST/EDT) or 401-658-4226. To order by Fax: TOLL FREE in the US and Canada: 1-800-406-9145 or 401-531-2801. To order by e-mail:[email protected]


NBER Working Papers On-Line

A complete list of all NBER Working Papers with searchable abstracts, and the full texts of Working Papers (issued sinceNovember 1994) are available at http://www.nber.org/wwp.html to anyone located at a university or other organization that sub-scribes to the (hard copy) Working Paper series.

If you believe that your organization subscribes, but you cannot access the online Working Paper service, please e-mail theNBER at [email protected] for more information and assistance.

*Individual copies of NBER Working Papers, Historical Factors in Long-Run Growth Papers, and Technical Papers are avail-

able free of charge to Corporate Associates. For all others, there is a charge of $10.00 per hardcopy or $5.00 per downloadedpaper. (Outside the United States, add $10.00 per order for postage and handling.) Advance payment is required on allorders. To order, call the Publications Department at (617)868-3900 or visit www.nber.org/papers. Please have ready the num-ber(s) of any Working Paper(s) you wish to order.

Subscriptions to the full NBER Working Paper series include all 500 or more papers published each year. Subscriptions arefree to Corporate Associates. For others within the United States, the standard rate for a full subscription is $2200; for academiclibraries and faculty members, $1275. Higher rates apply for foreign orders. The on-line standard rate for a full subscription is $1560and the on-line academic rate is $630. Partial Working Paper subscriptions, delineated by program, are also available.

For further information, see our Web site, or please write: National Bureau of Economic Research, 1050 MassachusettsAvenue, Cambridge, MA 02138-5398.

*Titles of all papers issued since July 2003 are presented below. For previous papers, see past issues of the NBER Reporter.

Working Papers are intended to make results of NBER research available to other economists in preliminary form to encourage dis-cussion and suggestions for revision before final publication. They are not reviewed by the Board of Directors of the NBER.

Current Working Papers

Paper Author(s) Title

NBER Working Papers

9810 Youngjae Lim Bankruptcy Policy Reform and Total FactorChin Hee Hahn Productivity Dynamics in Korea: Evidence from Micro Data

9811 Joseph G. Altonji The Marginal Propensity to Spend on Adult ChildrenErnesto Vilanueva

9812 Jonathan Meer Insurance and the Utilization of Medical ServicesHarvey S. Rosen

9813 Lucian Arye Bebchuk Executive Compensation as an Agency ProblemJesse M. Fried

9814 Alan J. Auerbach The Case for Open-Market Purchases in a Liquidity Trap Maurice Obstfeld

9815 Douglas A. Irwin Causing Problems? The WTO Review of Causation and Injury Attribution inU.S. Section 201 Cases

9816 Paul Gompers Entrepreneurial Spawning: Public Corporations and the Genesis of New Josh Lerner Ventures, 1986-1999David Scharfstein

9817 Sebastian Edwards Stock Market Cycles, Financial Liberalization, and Volatility Javier Gomez BiscarriFernando Perez de Gracia


9818 James J. Heckman The Determinants of Participation in a Social Program: Evidence from a Jeffrey A. Smith Prototypical Job Program

9819 Lawrence J. Christiano What Happens After a Technology Shock?Martin EichenbaumRobert Vigfusson

9820 Sebastian Edwards Strict Dollarization and Economic Performance: An Empirical InvestigationI. Igal Magendzo

9821 Anne C. Case Broken Down by Work and Sex: How our Health Declines Angus Deaton

9822 Angus Deaton Measuring Poverty in a Growing World (or Measuring Growth in a Poor World)

9823 Brian R. Copeland Trade, Growth, and the EnvironmentM. Scott Taylor

9824 H. Naci Mocan Guns, Drugs, and Juvenile Crime: Evidence from a Panel of Siblings and TwinsErdal Tekin

9825 Michael R. Darby Grilechesian Breakthroughs: Inventions of Methods of Inventing and Firm Lynne G. Zucker Entry in Nanotechnology

9826 Helen Levy What Do People Buy when they Don’t Buy Health Insurance and What DoesThomas DeLeire that Say about why they are Uninsured?

9827 William H. Dow Aggregation and Insurance-Mortality EstimationKristine A. GonzalezLuis Rosero-Bixby

9828 Guillermo A. Calvo Sudden Stops, the Real Exchange Rate, and Fiscal Sustainability:Alejandro Izquierdo Argentina’s LessonsErnesto Talvi

9829 Jean Boivin Are More Data Always Better for Factor Analysis?Serena Ng

9830 Orazio Attanasio Trade Reforms and Wage Inequality in ColombiaPinelopi AttanasioNina Pavcnik

9831 Ted Joyce Chip Shots: Association Between the State Children’s Health Insurance Programs Andrew Racine and Immunization Coverage and Delivery

9832 Robert Barsky Do Flexible Durable Goods Prices Undermine Sticky Price Models?Christopher L. HouseMiles Kimball

9833 Michael Kremer Why Are Drugs More Profitable Than Vaccines?Christopher M. Snyder

9834 Anna Pavlova Asset Prices and Exchange RatesRoberto Rigobon

9835 Claudio Raddatz Monetary Policy and Sectoral Shocks:Roberto Rigobon Did the Fed React properly to the High-Tech Crisis?

9836 Ken Hendricks Bidding Rings and the Winner’s Curse:Robert Porter The Case of the Federal Offshore Oil and Gas Lease AuctionsGuofu Tan

9837 Bennett T. McCallum Multiple-Solution Indeterminancies in Monetary Policy Analysis



9838 Bennett T. McCallum Monetary Policy in Economies with little or no Money

9839 Laurent Calvet Regime-Switching and the Estimation of Multifractal Processes Adlai Fisher

9840 Laurent Calvet Financial Innovation, Market Participation, and Asset PricesMartín Gonzalez-EirasPaolo-Sodoni

9841 Michael D. Bordo How “Original Sin” was Overcome: The Evolution of External Debt Christopher Meissner Denominated in Domestic Currencies in the United States and the BritishAngela Redish Dominions, 1800-2000.

9842 Louis Kaplow Public Goods and the Distribution of Income

9843 David F. Bradford Addressing the Transfer-Pricing Problem in an Origin-Basis X Tax

9844 Michael Greenstone Bidding for Industrial Plants: Does Winning a “Million Dollar Plant”Enrico Moretti Increase Welfare?

9845 Kent Smetters Is the Social Security Trust Fund Worth Anything?

9846 William Easterly New Data, New Doubts: A Comment on Burnside and Dollar’s “Aid Policies,Ross Levine and Growth” (2000)David Roodman

9847 Michael Chernew Quality and Employers’ Choice of Health PlanGautam GowrisankaranCatherine McLaughlinTeresa Gibson

9848 Martin Lettau Understanding Trend and Cycle in Asset Values:Sydney Ludvigson Reevaluating the Wealth Effect on Consumption

9849 Robert Gibbons Enriching a Theory of Wage and Promotion Dynamics inside FirmsMichael Waldman

9850 Claudio E. Montenegro Who Benefits from Labor Market Regulations? Chile, 1960-1998Carmen Pages

9851 David Neumark The Effects of Changes in State SSI Supplements on Pre-Retirement Elizabeth T. Powers Labor Supply

9852 Louis Kaplow The Value of a Statistical Life and the Coefficient of Relative Risk Aversion

9853 Daniel S. Hamermesh Beauty in the Classroom: Professors’ Pulchritude and Putative Pedagogical Amy M. Parker Productivity

9854 Paul W. Rhode After the War Boom: Reconversion on the U.S. Pacific Coast, 1943-49

9855 Michael Smart Tax Credits and the Use of Medical CareMark Stabile

9856 David W. Galenson Literary Life Cycles: The Careers of Modern American Poets

9857 Joshua L. Rosenbloom The Decline and Rise of Interstate Migration in the United States:William A. Sundstrom Evidence from the IPUMS, 1850-1990

9858 Lubos Pastor Stock Prices and IPO WavesPietro Veronesi

9859 James H. Stock Understanding Changes in International Business Cycle DynamicsMark W. Watson

9860 Michael D. Bordo Why didn’t France Follow the British Stabilization after World War One?Pierre-Cyrille Hautcoeur



9861 Martin B. Haugh Evaluating Portfolio Policies: A Duality ApproachLeonid KoganJiang Wang

9862 Stephanie Schmitt-Grohe Anticipated Ramsey Reforms and the Uniform Taxation Principle:Martin Uribe the Role of International Financial Markets

9863 Jay Bhattacharya Market Evidence of Misperceived Prices and Mistaken Mortality Risks Dana GoldmanNeeraj Sood

9864 Guillermo A. Calvo Explaining Sudden Stops, Growth Collapse, and BOP Crises:The Case of Distortionary Output Taxes

9865 Elsa V. Artadi The Economic Tragedy of the 20th Century: Growth in Africa Xavier Sala-i-Martin

9866 Christina D. Romer A New Measure of Monetary Shocks: Derivation and ImplicationsDavid H. Romer

9867 Sebastian Edwards Flexible Exchange Rates as Shock AbsorbersEduardo Levy Yeyati

9868 Chiaki Moriguchi Did American Welfare Capitalists Breach their Implicit Contracts? Preliminary Findings from Company-Level Data, 1920-1940

9869 Peter H. Lindert Why the Welfare State Looks Like a Free Lunch

9870 Robert W. Fogel Who Gets Health Care?Chulhee Lee

9871 Leemore S. Dafny Entry Deterrence in Hospital Procedure Markets:A Simple Model of Learning-By-Doing

9872 Kevin H. O’Rourke Heckscher-Ohlin Theory and Individual Attitudes Towards Globalization

9873 Marianne Bertrand Are Emily and Greg More Employable than Lakisha and Jamal? A Field Sendhil Mullainathan Experiment on Labor Market Discrimination

9874 Patricia M. Danzon The Impact of Price Regulation on the Launch Delay of New Drugs —Y. Richard Wang Evidence from Twenty-Five Major Markets in the 1990sLiang Wang

9875 Kathryn M. E. Dominguez When Do Central Bank Interventions Influence Intra-Daily and Longer-Term Exchange Rate Movements?

9876 Michael Kremer Peer Effects and Alcohol Use Among College Students Dan M. Levy

9877 James J. Heckman Selection Bias, Comparative Advantage, and Heterogeneous Returns toXuesong Li Education: Evidence from China in 2000

9878 Donald Boyd Analyzing the Determinants of the Matching of Public School Teachers to Hamilton Lankford Jobs: Estimating Compensating Differentials in Imperfect Labor MarketsSusanna LoebJames Wyckoff

9879 Rana Hasan Trade Reforms, Labor Regulations, and Labor-Demand Elasticities:Devashish Mitra Empirical Evidence from IndiaK.V. Ramaswamy

9880 Robert P. Flood Financial Integration: A New Methodology and an Illustration Andrew K. Rose



9881 Karsten Hansen The Effects of Schooling and Ability on Achievement Test ScoresJames J. HeckmanKathleen J. Mullen

9882 Rafael La Porta What Works in Securities Laws?Florencio Lopez-de-SilanesAndrei Shleifer

9883 Elizabeth W. Croft Fees and Surcharging in Automatic Teller Machine Networks: Non-BankBarbara J. Spencer ATM Providers versus Large Banks

9884 Athanasios Orphanides Imperfect Knowledge, Inflation Expectations, and Monetary Policy John C. Williams

9885 Geoffrey Heal You Only Die Once: Managing Discrete Interdependent RisksHoward Kunreuther

9886 Edward L. Glaeser Cities, Regions, and the Decline of Transport CostsJanet E. Kohlhase

9887 Brian J. Hall Six Challenges in Designing Equity-Based Pay

9888 Bradley Herring Incentive-Compatible Guaranteed Renewable Health Insurance Mark Pauly

9889 Patrick Bajari Are Structural Estimates of Auction Models Reasonable?Ali Hortacsu Evidence from Experimental Data

9890 Asli Demirguc-Kunt Regulations, Market Structure, Institutions, and the CostLuc Laeven of Financial IntermediationRoss Levine

9891 Patrick Bajari Estimating Housing Demand with an Application to Explaining Racial Matthew E. Kahn Segregation in Cities

9892 James Poterba Utility Evaluation of Risk in Retirement Saving Accounts Joshua RauhSteven VentiDavid Wise

9893 H. Henry Cao Inventory InformationRichard K. LyonsMartin D. D. Evans

9894 Patric H. Hendershott Investor Rationality: Evidence from UK Property Capitalization RatesBryan D. MacGregor

9895 James J. Heckman Simulation and Estimation of Nonadditive Hedonic ModelsRosa MatzkinLars Nesheim

9896 Richard B. Freeman What, Me Vote?

9897 Florian Heiss Healthy, Wealthy, and Knowing Where to Live: Trajectories of Health,Michael Hurd Wealth, and Living Arrangements Among the Oldest OldAxel Börsch-Supan

9898 Ricardo J. Caballero Adjustment is much Slower than you ThinkEduardo M.R.A. Engel

9899 Eiichi Tomiura Changing Geography and Vertical Linkages in Japan

9900 Paul R. Bergin Does Exchange Rate Risk Matter for Welfare?Ivan Tchakarov



9901 Dalton Conley A Pound of Flesh or Just Proxy? Using Twin Differences to Estimate Kate Strully the Effect of Birth Weight on Life ChancesNeil G. Bennett

9902 Axel Börsch-Supan Household Saving in Germany: Results of the First SAVE StudyLothar Essig

9903 Stephen M. Maurer Procuring Knowledge Suzanne Scotchmer

9904 David Austen-Smith The Economics of “Acting White”Roland G. Fryer, Jr.

9905 Pierpaolo Benigno Optimal Monetary and Fiscal Policy: A Linear-Quadratic ApproachMichael Woodford

9906 Joshua Aizenman On the Hidden Links Between Financial and Trade Opening

9907 Anna Aizer Parental Medicaid Expansions and Health Insurance Coverage Jeffrey Grogger

9908 Carmen M. Reinhart Debt IntoleranceKenneth S. RogoffMiguel A. Savastano

9909 Petra Moser How do Patent Laws Influence Innovation? Evidence from Nineteenth-Century World Fairs

9910 Ivar Ekeland Identification and Estimation of Hedonic ModelsJames J. HeckmanLars P. Nesheim

9911 Kevin Lang The Pricing of Job Characteristics when Markets do not Clear:Sumon Majumdar Theory and Policy Implications

9912 Stephen T. Parente The Role of Consumer Knowledge of Insurance BenefitsDavid Salkever in the Demand for Preventative HealthJoan DaVanzo

9913 Axel Börsch-Supan Pension Reform in Germany: The Impact on Retirement DecisionsBarbara Berkel

9914 Alessandro Beber The Effect of Macroeconomic News on Beliefs and Preferences:Michael W. Brandt Evidence from the Options Market

9915 Yacine Aït-Sahalia Disentangling Volatility from Jumps

9916 Casey B. Mulligan Capital Tax Incidence: Fisherian Impression from the Time Series

9917 James Choi Passive Decisions and Potent DefaultsDavid LaibsonBrigitte MadrianAndrew Metrick

9918 Hope Corman Mothers’ and Fathers’ Labor Supply in Fragile Families:Nancy E. Reichman The Role of Child HealthKelly Noonan

9919 Mark V. Pauly Adverse Selection and the Challenges to Stand-Alone Prescription Drug Yuhui Zeng Insurance

9920 Kyle Bagwell The Case for Auctioning Countermeasures in the WTO Petros C. MavroidisRobert W. Staiger



9921 Thorsten Beck Bank Concentration and CrisesAsli Demirguc-KuntRoss Levine

9922 Severin Borenstein On the Efficiency of Competitive Electricity Markets With Time-Invariant Stephen P. Holland Retail Prices

9923 Jeremy Atack Capital Deepening in American Manufacturing, 1850-1880Fred BatemanRobert A. Margo

9924 Jason G. Cummins A New Approach to the Valuation of Intangible Capital

9925 Mark V. Pauly Price Elasticity of Demand for Term Life InsuranceKate H. Withers and Adverse SelectionKrupa Subramanian-ViswanathanJean LemaireJohn C. HersheyKatrina ArmstrongDavid A. Asch

9926 Jeff Dominitz How Should We Measure Consumer Confidence (Sentiment)?Charles F. Manski Evidence from the Michigan Survey of Consumers

9927 Hui Guo Uncovering the Risk-Return Relation in the Stock Market Robert F. Whitelaw

9928 Francesco Caselli Importing TechnologyDaniel Wilson

9929 Robert G. King Monetary Discretion, Pricing Complementarity, and Dynamic Multiple EquilibriaAlexander L. Wolman

9930 Michael Faulkender Does the Source of Capital Affect Capital Structure? Mitchell Petersen

9931 Gilles Duranton Micro-Foundations of Urban Agglomeration Economies Diego Puga

9932 Andres Velasco Tough Policies, Incredible Policies? Alejandro Neut

9933 Dora L. Costa Becoming Oldest-Old: Evidence from Historical U.S. Data Joanna Lahey

9934 Daron Acemoglu Unbundling Institutions Simon Johnson

9935 David W. Galenson The Reappearing Masterpiece: Ranking American Artists and Art Works ofthe Late Twentieth Century

9936 Tibor Besedes On the Duration of Trade Thomas J. Prusa

9937 Sean Nicholson The Magnitude and Nature of Risk Selection in Employer-SponsoredM. Kate Bundorf Health PlansRebecca M. SteinDaniel Polsky

9938 Roland G. Fryer The Causes and Consequences of Distinctively Black Names Steven D. Levitt

9939 Marc P. Giannoni Optimal Inflation Targeting Rules Michael Woodford



9940 Christopher Blattman The Terms of Trade and Economic Growth in the Periphery, 1870-1938Jason Hwang Periphery Jeffrey G. Williamson

9941 Robert W. Fogel Changes in the Process of Aging during the Twentieth Century: Findings and Procedures of the Early Indicators Project

9942 Joel Waldfogel Does Information Undermine Brand? Information Intermediary Use Lu Chen and Preference for Branded Web Retailers

9943 Douglas A. Irwin The Aftermath of Hamilton’s “Report on Manufactures”

9944 Douglas A. Irwin Trade Disruptions and America's Early Industrialization Joseph H. Davis

9945 Pol Antras Incomplete Contracts and the Product Cycle

9946 Robert G. King Partial Adjustment without Apology Julia K. Thomas

9947 Erkan Erdem Trade Policy and Industrial Sector Responses:James Tybout Using Evolutionary Models to Interpret the Evidence

9948 Nelson Mark Official Interventions and Occasional Violations of Uncovered Interest ParityYoung-Kyu Moh in the Dollar-DM Market

9949 Eric Friedman Propping and TunnelingSimon JohnsonTodd Mitton

9950 Ajay Agrawal Gone but not Forgotten: Labor Flows, Knowledge Spillovers, and Enduring Iain M. Cockburn Social CapitalJohn McHale

9951 Sheridan Titman Capital Investments and Stock ReturnsK.C. John WeiFeixue Xie

9952 Alison Evans Cuellar The Relationship between Mental Health and Substance Abuse Treatment Sara Markowitz and Juvenile CrimeAnne M. Libby

9953 Donald Boyd The Draw of Home: How Teachers' Preferences for Proximity Disadvantage Hamilton Lankford Urban SchoolsSusanna LoebJames Wyckoff

9954 Susanna Loeb Child Care in Poor Communities: Early Learning Effects of Type,Bruce Fuller Quality, and StabilitySharon Lynn KaganBidemi CarrolJudith CarrollJan McCarthy

9955 Daniel Kessler Advance Directives and Medical Treatment at the End of LifeMark B. McClellan

9956 Evan Gatev Banks’ Advantage in Hedging Liquidity Risk: Theory and Evidence fromPhilip E. Strahan the Commercial Paper Market

9957 Amy Finkelstein Private Information and its Effect on Market Equilibrium: New Evidence fromKathleen McGarry Long-Term Care Insurance

9958 Claudia Goldin The “Virtues” of the Past: Education in the First Hundred Years of theLawrence F. Katz New Republic



9959 Hanno Lustig Housing Collateral, Consumption Insurance, and Risk Premia:Stijn Van Nieuwerburgh An Empirical Perspective

9960 Bennett T. McCallum The Unique Minimum State Variable RE Solution is E-Stable in all Well Formulated Linear Models

9961 Bennett T. McCallum Is the Fiscal Theory of the Price Level Learnable?

9962 Howard Bodenhorn The Economics of Identity and the Endogeneity of Race Christopher S. Ruebeck

9963 Rosalie Liccardo Pacula Does Marijuana Use Impair Human Capital Formation? Karen E. RossJeanne Ringel

9964 Jorn-Steffen Pischke The Impact of Length of the School Year on Student Performance and Earnings:Evidence from the German Short School Year

9965 Alvin J. Silk Scale and Scope Economies in the Global Advertising and MarketingErnst R. Berndt Services Business

9966 Jaison R. Abel Price Indexes for Microsoft’s Personal Computer Software ProductsErnst R. BerndtAlan G. White

9967 Robert E. Hall Wage Determination and Employment Fluctuations

9968 Gauti B. Eggertsson Optimal Monetary Policy in a Liquidity TrapMichael Woodford

9969 Martin Feldstein Monetary Policy in an Uncertain Environment

9970 Gadi Barlevy The Cost of Business Cycles under Endogenous Growth

9971 Michael P. Dooley An Essay on the Revised Bretton Woods SystemDavid Folkerts-LandauPeter Garber

9972 Leemore S. Dafny How Do Hospitals Respond to Price Changes?

9973 David G. Blanchflower What Effect do Unions Have on Wages now and WouldAlex Bryson “What Do Unions Do” Be Surprised?

9974 Jonathan Lewellen The Conditional CAPM does not Explain Asset-Pricing AnomaliesStefan Nagel

9975 David McCarthy International Adverse Selection in Life Insurance and AnnuitiesOlivia S. Mitchell

9976 Melvin Stephens Jr. The Consumption Response to Predictable Changes in Discretionary Income:Evidence from the Repayment of Vehicle Loans

9977 Susan Averett Unemployment Risk and Compensating Differential in Late-Nineteenth Howard Bodenhorn Century New Jersey ManufacturingJustas Staisiunas

9978 David Popp Lessons From Patents: Using Patents toMeasure Technological Change in Environmental Models

9979 Chris Forman How did Location Affect Adoption of the Commercial Internet? Avi Goldfarb Global Village, Urban Density, and Industry CompositionShane Greenstein

9980 C. Lanier Benkard Hedonic Price Indexes with Unobserved Product Characteristics,Patrick Bajari and Application to PC’s

9981 Marvin Goodfriend Inflation Targeting in the United States?



9982 Alessandra Casella An Experimental Study of Storable VotesAndrew GelmanThomas R. Palfrey

9983 Alan J. Auerbach Generational Accounting in KoreaYoung Jun Chun

9984 Ignazio Angeloni Monetary Transmission in the Euro Area:Anil K. Kashyap Does the Interest Rate Channel Explain All?Benoit MojonDaniele Terlizzese

9985 Ignazio Angeloni The Output Composition Puzzle: A Difference in the Monetary Transmission Anil K. Kashyap Mechanism in the Euro Area and U.S.Benoit MojonDaniele Terlizzese

9986 Peter C. Reiss Demand and Pricing in Electricity Markets: Evidence from San Diego Matthew W. White during California’s Energy Crisis

9987 Ann Bartel Can a Work Organization Have an Attitude Problem? Richard Freeman The Impact of Workplaces on Employee AttitudesCasey Ichniowski and Economic OutcomesMorris M. Kleiner

9988 Raj Chetty A New Method of Estimating Risk Aversion

9989 Stanley L. Engerman Institutional and Non-Institutional Explanations of Economic DifferencesKenneth L. Sokoloff

9990 Rebecca Menes Corruption in Cities: Graft and Politics in American Cities at the Turn ofthe Twentieth Century

9991 Jerry G. Thursby Are Faculty Critical? Their Role in University-Industry LicensingMarie C. Thursby

9992 Richard B. Freeman What Do Unions Do ... to Voting?

9993 Dirk Krueger On the Welfare Consequences of the Increase in Inequality in the United States Fabrizio Perri

9994 Jonathan Klick Are Mental Health Insurance Mandates Effective?Sara Markowitz Evidence from Suicides

9995 Malcolm Baker Appearing and Disappearing Dividends:Jeffrey Wurgler The Link to Catering Incentives

9996 M. Kate Bundorf The Effects of Offering Health Plan Choice within Employment-BasedPurchasing

9997 Nicholas Barberis Individual Preferences, Monetary Gambles, and the Equity PremiumMing HuangRichard Thaler

9998 Andrew B. Bernard Relative Wage Variation and Industry LocationStephen ReddingPeter K. SchottHelen Simpson

9999 Leora Friedberg Retirement and the Evolution of Pensions StructureAnthony Webb

10000 Richard B. Freeman Trade Wars: The Exaggerated Impact of Trade in Economic Debate

10001 Dirk Krueger US-Europe Differences in Technology-Driven Growth:Krishna B. Kumar Quantifying the Role of Education




10002 Alvin E. Roth Kidney ExchangeM. Utku UnverTayfun Sonmez

10003 Diego Comin Medium Term Business CyclesMark Gertler

10004 Eli Berman Hamas, Taliban, and the Jewish Underground: An Economist’s View ofRadical Religious Militias

10005 Louis Kaplow Concavity of Utility, Concavity of Welfare, andRedistribution of Income

*

NA

TIO

NA

L B

UR

EA

U O

F E

CO

NO

MIC

RE

SEA

RC

H

NB

ER

Reporter

1050 Massach

usetts A

venu

eC

amb

ridge, M

assachu

setts 02138-5398(617) 868-3900

Ch

ange Service R

equ

ested

Nonprofit O

rg.U

.S. PostagePAID

National Bureau of

Economic R

esearch

nber reporter · nber reporterfall 2003 1. ... modern macroeconomics during the past quar- ......

Documents