NBER Reporter Winter 06NBER ReporterWinter 2005/6 1 Public Economics James M. Poterba* Researchers in the NBER Public Economics Program study many of the core issues that have been

NBER Reporter Winter 2005/6 1

Public Economics

James M. Poterba*

Researchers in the NBER Public Economics Program study many ofthe core issues that have been at the center of recent national policydebates. While the Public Economics Program is broadly concerned withthe economic role of government, an expansive definition that includessome research in virtually every sub-field of economics, two of its mostimportant research themes are the economics of taxation and the analysisof social insurance programs.

Since the last Public Economics Program Report in 2001, the UnitedStates has undergone substantial tax reform in the form of the 2003 and2004 tax bills. Because many of the tax reform provisions that were enact-ed in 2001 and 2003 are scheduled to expire later this decade, further taxreforms have already been enacted in a sense. Policy debate about theextension of these tax provisions, and about the structure of the tax sys-tem more generally, seems very likely to continue through the next fewyears.

Tax reform has been widely discussed and there have been substantialchanges in the last five years. In contrast, Social Security reform has alsobeen widely discussed, but there have been no significant changes in theprogram’s structure. Public programs for retirement income support havebeen active topics of discussion in many industrialized nations. In theUnited States, the earnest discussion of Social Security reform began whena Presidential commission suggested several reform proposals in 2001.Since then, various policy analysts and legislators have advanced a range ofdifferent proposals for reform. They differ in the role that they envision forthe government in providing retirement income, and in their potentialeffects on the long-run fiscal balance of the Social Security system.Medicare, which portends to become an even more costly entitlement pro-

WINTER 2005/6RReeppoorrtteerr OOnnLLiinnee at: www.nber.org/reporter

* Poterba directs the NBER’s Program on Public Economics and is a Professor of Economicsat MIT. In this article, the numbers in parentheses refer to NBER Working Papers.

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Program Report

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Program Report:Public Economics 1

Research Summaries:Contribution of Science … to Production 8

Foreign Direct Investment Behavior of MNCs 11Race and … American Economic History 15

Globalization and … Economic History 18

NBER Profiles 22Conferences 24

Bureau News 36Bureau Books 57

Current Working Papers 58

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gram over the long-term future, has attractedless policy attention than Social Security.

The NBER Public Economics Programincludes a very diverse group of researchers.Nearly 120 Faculty Research Fellows andResearch Associates claim affiliation with theprogram, although only half of thoseresearchers cite Public Economics as their pri-mary affiliation. Program affiliates have a longtradition of analyzing tax policies and of study-ing social insurance programs such as SocialSecurity. They also study a very wide range ofother topics, including environmental econom-ics, political economy, and health economics.Program members meet twice each year at pro-gram meetings, and again for a variety of work-shops during the NBER Summer Institute. Inthe last four years, there have been eight pro-gram meetings and more than twenty SummerInstitute group meetings. Since late 2001, pro-gram affiliates have disseminated 605 workingpapers, or more than one sixth of all NBERpapers, and published six books and a numberof special issues of academic journals.

One recent innovation in the PublicEconomics group is the creation of severalworking groups that tackle specific researchissues related to various topics in public policy.One such group, which Martin Feldstein and Ihave co-directed, focuses on the BehavioralResponses to Taxation. Its members are drawnfrom the U.S. Treasury Department, theCongressional Budget Office, and the JointCommittee on Taxation, as well as fromNBER’s ranks. This group has met to discusscompleted research about, and the researchagenda for, the link between tax rates and vari-ous dimensions of taxpayer behavior such aslabor supply, capital gain realizations, and thereporting of aggregate taxable income. TheWorking Group has scheduled meetings justbefore or just after Program Meetings, or duringthe NBER’s Summer Institute, to maximize par-ticipation by the NBER affiliates. A second suchgroup directed by NBER Research AssociateDouglas Shackelford of the University of NorthCarolina focuses on Financial Accounting andTaxation. It includes researchers in the fields ofaccounting, finance, and public finance. Its agen-da includes issues at the intersection of public

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finance and accounting, for exampleexplaining the growing disparitiesbetween book and tax income for U.S.corporations and evaluating the impactof various tax reform proposals onaccounting earnings and corporate bal-ance sheets.

A brief report such as this cannot dojustice to the breadth of research that iscarried out by Public EconomicsProgram members while also explainingthe substantive contributions of thisresearch. I have therefore decided tofocus here on four broad areas: taxation,social insurance programs, political econ-omy, and the economics of the state andlocal government sector. Because taxa-tion issues are studied exclusively byresearchers in the Public Economicsgroup, while Aging, Economic Fluctua-tions and Growth, and Well-Being ofChildren Program researchers studysome of the other issues (and theirresearch is described in other ProgramReports), I will devote more than equaltime to the issues related to taxation. Iwill describe how Program membershave approached a variety of topics, andI will briefly summarize their key researchfindings. This report unfortunatelyexcludes far more research than itincludes, and I apologize to theresearchers whose work is not mentionedin this summary.

The Economic Effects of TaxReform

There have been three importantfederal tax changes in the last five years.The 2001 Economic Growth and TaxRelief Reconciliation Act reduced mar-ginal tax rates under the federal incometax, although budgetary pressures neces-sitated temporary rather than permanenttax reductions. The 2003 Job Growthand Taxpayer Relief Reconciliation Actreduced marginal tax burdens on divi-dend income by as much as 20 percent-age points for some households, thereby

significantly reducing the relative tax bur-den on dividends relative to corporateretained earnings that generate capitalgains. The 2004 tax bill introduced a tran-sitory tax holiday for firms repatriatingearnings from foreign subsidiaries, and itcreated a range of specialized provisionsto encourage specific business activities.Researchers in the NBER PublicEconomics Program have analyzed theeconomic effects of tax changes similarto those embodied in each of these taxbills. As data on taxpayer response to thetax reforms has become available, theyhave also provided a rapid evaluation ofactual behavioral changes in response totax rules.

The tax changes of 2001, whichwere temporary, phased-in gradually, andincluded an immediate tax rebate as ameans of stimulating economic activity,have generated several lines of researchon tax policy and household behavior. Anumber of studies have explored howconsumers responded to the increase inaftertax income that resulted from theimmediate tax rebate (10784, 9308).These studies suggest that most house-holds spent between half and three quar-ters of their tax rebate within six monthsof receiving the rebate, and that thespending effects were greatest for house-holds with low levels of financial wealth.Other research has examined how thechanges in investment incentives affectedcorporate investment activity (10415),and how the reduction in individualincome tax liabilities raised the impor-tance of the Alternative Minimum Taxfor many individual taxpayers (10072).One of the central issues in analyzing anytax reform that changes marginal taxrates is how it will affect the amount oftaxable income reported on tax returns,since this determines the revenue effectsof the tax reform. NBER researchershave played a central role in developingestimates of the elasticity of taxableincome with respect to marginal tax rates,and recent work supports earlier findings

of a substantial reporting response tochanges in tax rates (10273, 10044).

Taxable income is the sum of manycomponents, each of which is may beaffected to different degrees by changesin marginal tax rates and in the structureof the tax base. Not surprisingly, a sub-stantial body of research has examinedthe components of taxable income andtheir sensitivity to the tax system. Oneitem that has attracted attention is themortgage interest deduction. It has beenactively discussed of late because thePresident’s Advisory Panel on TaxReform suggested tightening current lim-its. Several recent studies have exploredthe economic effects of the currentdeduction rules and the distribution ofthe resulting tax deductions acrossincome groups and geographic locations(10322, 9284). Because house prices dif-fer widely, there are large differences inthe average value of mortgage interestdeductions across states, with much high-er values on the East and West Coastthan in Mid-western states. Otherresearch has considered the effect ofchanges in the home mortgage interestdeduction in other nations, with particu-lar emphasis on the United Kingdom(11489, 9207).

Another active topic of research onthe individual income tax is the linkbetween current tax rules and incentivesfor entrepreneurial activity. Two studieshave explored how the progressive struc-ture of the individual income tax, and theinterplay between the individual and thecorporate income tax, affect entrepre-neurial activity (9226, 9015). The impor-tant role that start-up businesses play insupporting research and developmentand encouraging job growth makes itimportant to understand how tax incen-tives affect the creation of new enterpris-es. Other topics that have attracted atten-tion are the influence of tax incentives onpurchases of health insurance and healthcare (10977, 9567, 8657, 9855), the linkbetween taxation and labor supply

4 NBER Reporter Winter 2005/6 ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

(10316, 10935, 10139, 9429, 8774), thesensitivity of capital gain realizations tomarginal income tax rates (10275, 9674,8745), the economic effects of excisetaxes on goods such as cigarettes (8872,8777) and alcohol (8562), and the impactof tax incentives on charitable giving(10374). The Earned Income Tax Creditand its effect on the labor supply of low-income households has been widely stud-ied (11768, 11454, 11729). While many ofthese studies emphasize specific issues ofincome tax policy, NBER researchers arestill examining the broad issues raised byfundamental tax reform, such as the eco-nomic effects of shifting toward a con-sumption tax (9492, 9596), the funda-mental determinants of tax evasion(8551), the theory of optimal taxation(10490, 10407, 10119, 10099, 9415,9046), and the accurate measurement ofthe distribution of tax burdens acrosshouseholds (8978, 8829).

Discussions of consumption taxa-tion and of fundamental tax reformfocus attention on the current tax rulesthat affect saving, and in particular onopportunities for earning before-taxreturns in a variety of specializedaccounts such as Individual RetirementAccounts and 401(k) plans. The analysisof retirement saving programs has been avery active area of research in PublicEconomics, and the ongoing researchhas drawn insights from behavioral eco-nomics (11518), financial economics, andmany other sub-fields. In addition tostudying how the availability of these sav-ing programs affects wealth accumula-tion (11680, 9096, 8610), a number ofstudies have shown that participants inemployer-provided saving programs arevery sensitive to default options, peerbehavior, and other considerations thatare usually outside the neoclassical eco-nomics analysis of saving choices (11554,11726, 9131, 8885, 8655). Research hasexplored the potential use of plan defaultprovisions to encourage saving (11074)as well as the role that employer matching

of participant contributions may play inraising participation rates (10419).Another strand of research has consid-ered how assets held in tax-deferredaccounts should be valued from the per-spective of a household trying to com-pute a balance sheet that includes bothtaxable and tax-deferred assets (10395).Related work has studied the asset alloca-tion choices that households make whenthey participate in tax-deferred accounts,and it has contrasted these choices withthe predictions of simple models of tax-efficient asset location (9268).

The tax changes of 2003 focused onthe taxation of corporate capital income.By reducing the maximum individualincome tax rate on dividend income to 15percent, instead of the top rate of morethan 35 percent that prevailed in previousyears, the 2003 reform substantiallyreduced the tax incentive for firms toretain earnings or repurchase sharesrather than to distribute cash dividends.NBER Public Economics researchershave been studying the link between taxrules and corporate financial policy sincethe program was created, as the“Business Taxation and Finance” group,nearly thirty years ago. Not surprisingly,the dramatic change in dividend tax bur-dens stimulated many new research proj-ects. These include new studies of theresponsiveness of dividend payout withrespect to tax rates (10321, 10391, 10572,10841, 11449), and of the impact of the2003 tax reform on the market value offirms with different payout policies(11452). The empirical findings suggestthat in the months following the dividendtax reduction, firms increased dividendpayouts at a rate that had not been seenfor several decades. The tax change was acatalyst that reversed a decades-longdecline in corporate dividend payout.Many firms that were paying dividendsincreased their payouts, and many otherfirms initiated cash dividends. Researchon dividend policy has moved beyondthe simple documentation of higher pay-

out rates to study how firm characteris-tics, such as stock option holdings of topmanagers, affected the change in payoutin the aftermath of the tax change.Dividend increases were smaller at firmswhere managers have substantial hold-ings of options that would decline invalue if the firm paid out earnings as div-idends than at firms without such execu-tive option holdings (11002).

While the tax treatment of dividendshas attracted particular attention in thelast two years, NBER researchers havealso studied many other aspects of cor-porate income taxation. The decline incorporate tax payments during a periodof high profitability, and the popularclaim that U.S. corporations were movingoperations offshore to reduce their taxburden, have attracted an expanding setof researchers to issues of corporate tax-ation. Two recent studies have exploredthe source of the decline in corporate taxrevenues (9477, 9535), and a substantialbody of research has investigated theeffect of international tax rules on thebehavior of multinational firms (11717,11196, 10806, 10936, 8854). These stud-ies generally find that large disparities ineffective tax burdens across nations havethe effect of shifting the geographicalpattern of reported income and of somecorporate activities, although internation-al tax considerations do not appear tofully account for changes in corporate taxreceipts over time. Other studies haveanalyzed the determinants of corporatetax avoidance and tax planning (11241,11341, 10858, 10690, 10471, 11504) andthe interplay between tax avoidance andfinancial fraud (10978). Researchers haveinvestigated the differences between tax-able income and book income, and thepotential consequences of movingtoward a tax system that relied to a greaterextent on book income for the computa-tion of tax liability (11067, 8866), as wellas the role of new and sophisticatedfinancial products in affecting corporateincome tax liabilities (9243).


Much of the recent research on cor-porate income taxation has focused onemerging issues in the corporate sector,and a number of studies have linked thiswork back to long-standing concernssuch as the economic incidence of thecorporate income tax (11686, 9916,9374). Other studies have also exploredpotential reforms of the current corpo-rate tax structure by analyzing the designof cash-flow corporate taxes in openeconomies (10676, 9843) and the waythat the General Agreement on Tariffsand Trade (GATT) might treat variouschanges in the apportionment rules thatare applied to the worldwide income ofmultinational firms (9060).

The individual and the corporateincome taxes are the focus of mostPublic Economics research on tax policy,but there is always some research onother tax instruments. Several recentstudies have examined the estate tax andtried to summarize its incentive effects,both in theoretical models (11408) and inpractice (9456, 11025, 9661, 11767). Oneexplanation for the substantial flow ofwealth from one generation to the next isthat elderly households hold wealth toprepare for the possibility of late-lifemedical needs or other costs. This sug-gests that the impact of the tax code onhousehold behavior may be affected bythe structure of insurance markets. Anemerging literature is beginning toexplore this interaction (11185).

Most of the research describedabove focuses on the detailed provisionsof the tax rules affecting individuals orfirms. But the unusual nature of the 2001tax changes, in particular their temporarycharacter and the role of budgetary rulesin leading Congress to enact such taxpolicies, has stimulated new research onthe broad subject of budget rules and thelink between such rules and policy out-comes such as the budget deficit.Researchers have studied the effect ofsunset provisions on budget outcomes(10694), the potential impact on federal

taxes and spending of unifying the budg-ets of the Medicare and Social Securitytrust funds with the rest of the budget(10953), and the link among anti-deficitrules such as limits on government bor-rowing and fiscal policy outcomes(10788, 11065). More generally, recentpolicy debates concerning federal deficitshave led to renewed interest in the evolu-tion of fiscal policy in the United Statesand elsewhere (11630, 11600, 10788,10023, 9012), and to new analyses ofhow budget deficits and governmentdebt levels affect interest rates (10681).Recent research on this issue has movedbeyond earlier studies that consideredonly the contemporaneous correlationbetween asset markets and deficits, andbegun to model expected future fiscalpolicy and its impact on interest rates.

Social Security and OtherSocial Insurance Programs

One of the reasons that long-termfiscal policy projections have attracted somuch interest is the impending growth ofSocial Security and Medicare, programsthat provide retirement income andhealth insurance to elderly households.These programs represent the federalgovernment’s largest long-term commit-ments. It is therefore no surprise thatthese programs have been the focus ofan active research agenda by scholarsaffiliated with the Public EconomicsProgram. Much of this research is alsopart of the NBER Programs on Agingand on Health Care, and is consequentlysummarized in other Program Reports.Because the issues in Social Securityreform are particularly central to publiceconomics, I will describe several com-ponents of this research, and then dis-cuss social insurance research more gen-erally.

A number of studies have consid-ered the long-term fiscal health of theSocial Security program and computedthe present discounted value of prom-ised payouts less projected taxes, as well

as the sensitivity of such calculations tovarious assumptions (11060, 10969,10085, 9845). Other work has examinedpopular perceptions of future SocialSecurity benefits (9798); these percep-tions can have an important effect oncurrent saving decisions.

The projected shortfall of SocialSecurity payroll taxes relative to benefitpayments has stimulated numerous pro-posals for Social Security reform in theUnited States (8592, 11098). Someresearchers have explored the aggregateefficiency effects of adopting a “privateaccounts” Social Security program(11622, 11101). Others have focused onspecific design features of “privateaccounts” programs, such as alternativeasset allocation restrictions and returnguarantee programs for such accounts(11300, 11084, 9195, 8906, 8732,8731). The experience of Chile, a nationthat adopted a privatized account systemin the early 1980s, has been carefullychronicled (8924), and researchers havetried to predict the labor market effectsof a private accounts system (10305).An important strand of research hasconsidered the labor market effects ofexisting Social Security programs eitherby exploiting international differences inSocial Security programs to generate dif-ferences in retirement incentives (11290,9407) or by examining the incentives created by the Social Security programin the United States (10905, 9183,10030). Social Security redistributesresources within cohorts as well asacross generations, and recent researchhas examined how the Social Securityprogram has affected the economic sta-tus of the elderly and its distribution(10466, 8911,8625).

While a substantial group of NBERresearchers studies issues related to SocialSecurity, an even larger group investigatesthe wide array of other social insuranceprograms that currently operate in theUnited States and other developednations. This research touches on many


different programs and topics. Somework offers theoretical guidelines for thedesign of social insurance programs(11386, 11250, 10792). Two central issuesthat arise in evaluating any social insur-ance program are: the extent to which theprogram alleviates the problem that it isdesigned to address and the extent towhich it causes unintended distortions inthe behavior of recipients (8730). Manystudies have examined one or both ofthese issues in the context of specificsocial insurance programs, such as unem-ployment insurance (11760, 10500,10443, 10043), the Supplemental SecurityIncome program (11568), Medicaid(9058), Temporary Assistance for NeedyFamilies (TANF) (8749), disability insur-ance (9155, 9148, 10219), housing assis-tance programs (8709), and child caresubsidy programs (9693). Other studiesfocus on various aspects of behavioralresponse that arise in a number of differ-ent social insurance programs. Theseinclude the effect of such programs onhousehold saving (10487), the decision ofhouseholds with regard to benefit take-up (10488, 9818), the impact of socialinsurance and transfer programs on laborsupply (9168), and the link between socialinsurance programs and living arrange-ments (8774). As a result of empiricalstudies such as these, policymakers have amuch better description of the key inputsto social insurance program design.

Researchers in public economicshave long recognized that it is importantto study government-provided socialinsurance programs in a broad contextthat recognizes the many other ways inwhich resources may be transferred tohouseholds that experience adverse eco-nomic shocks of various kinds. Transferswithin families are one such alternativemechanism. Recent research has empha-sized two others: private insurance mar-kets and transfers from religious organi-zations. Some research has consideredhow imperfections in private insurancemarkets can provide a rationale for the

creation of government-provided socialinsurance programs, while other workrecognizes that the provision of socialinsurance may alter the operation of pri-vate insurance markets (11039, 10989,9714, 9031). The welfare effects of pub-lic programs can be very sensitive to theprivate market response. Studies of char-itable work by religious organizations,and how such work is affected by theprovision of government transfer pro-grams, represent a new direction for pub-lic economics researchers. Analysis oftransfers during the New Deal suggeststhat as public spending on anti-povertyefforts increased, private spendingthrough church-based relief effortsdeclined. This suggests a novel channelof crowd-out that has not been docu-mented heretofore. Future research onsocial insurance will undoubtedly contin-ue to explore both the way that potentialbeneficiaries respond to public programs,and the effect of public programs onother components of the economic sup-port network.

Political Economy, Legis-lative Structure, and PolicyOutcomes

Much of public economics is con-cerned with the consequences of variousgovernment policies. Research on theincidence of various taxes and on thebehavioral effects of various transferprograms fits this description. An impor-tant and growing strand of research,however, seeks to understand the linkbetween political institutions and policyoutcomes. This work asks why certainpolicies are enacted, not how such poli-cies would affect economic activity. Thisresearch on “political economy” crossesseveral NBER Programs, includingEconomic Fluctuations and Growth,Industrial Organization, and PublicEconomics.

There are many different elements ofpolitical economy research within the

Public Economics Program, but many ofthem are united by a central focus on thedeterminants of electoral or legislativerules, and the consequences of differentrules. Some work offers an explanationfor the political factors that underpin thechoice of different electoral rules in dif-ferent U.S. cities (11236). Another strandof research examines the factors thatinfluence bargaining power within legisla-tures (10530, 8973) and the link betweensuch power and legislative outcomes(10385, 9748). A third group of studiesexamine an even more general set ofissues about the links between electoralrules, the structure of political parties,and the choice of economic policies(10176, 10040). Political institutions areincreasingly recognized as affected by theunderlying tastes of voters, the power ofvarious interest groups, and the history ofpolitical jurisdictions (9006).

The recognition that political institu-tions matter for policy outcomes raisesthe related question of whether one setof institutions may be more efficient inresponding to some types of economicproblems than another institutionalstructure. One specific context in whichresearchers have explored this questionconcerns the choice between an appoint-ed regulator and an elected politician asthe decisionmaker in particular settings(10241). The findings suggest that politi-cians will be more likely to outperformregulators in settings that require com-pensating the losers from a policy action,that do not involve specialized technicalexpertise, and that do not feature smallbut powerful vested interests that benefitfrom or lose from the policy choice.

Another broad issue of interest inpolitical economy concerns “electionmechanics.” This area is concerned withthe factors that affect voting, campaignspending, candidate selection, and elec-toral outcomes. One example of suchresearch is the attempt to understand andexplain the apparent electoral advantageof incumbent officeholders (10748).


Another is the analysis of voter participa-tion. Several studies have explored eco-nomic and other factors that influencevoter turnout (9896, 8720, 10797, 11794),as well as the likelihood that an election isclose enough for an individual voter torationally believe that she might have asignificant chance of affecting the out-come (8590). Other work explores theeffect of campaign finance rules on theinfluence of interest groups and on poli-cy outcomes (9601, 8693), and the broadquestion of what determines the totalamount of campaign contributions andcampaign spending (9409).

One intriguing line of researchexplores how the identity of elected offi-cials, which may be affected by electoralrules, influences policy outcomes. Thiswork evaluates an Indian electoral reformthat reserved a significant share of elect-ed positions on local councils for womencandidates (8615). After this electoralreform, the set of policies chosen by thelocal councils shifted toward support forpublic programs that would be particular-ly beneficial for women rather than men.These findings reinforce other studiesthat suggest the important role played byelectoral institutions that affect the char-acteristics of winning candidates.

State and Local PublicFinance

While much of the tax policy debatein recent years has centered on the feder-al government, many important andongoing tax policy issues affect state andlocal governments. Recent research byPublic Economics Program affiliates hasexamined a number of these issues.There are wide disparities in fiscal struc-ture across states and localities. This pro-vides much wider variation in tax policiesthan at the federal level, and also resultsin large differences across locations in fis-cal balance (11203).

A key issue in state and local public

economics, as in its federal counterpart, isthe behavioral response of taxpayersconfronting the tax system. An exampleof research related to this issue is a studyof how property tax measures thatgrandfather a taxpayer’s taxable propertyvalue affect homeowner mobility(11108). School finance also providesmany opportunities for analyzing taxpay-er response. Recent work has analyzedschool finance reform programs in spe-cific states, such as Texas (10722), andlooked at the effect of state-level aid pro-grams on the tax and spending decisionsof local school districts (10701). A fea-ture that distinguishes state tax analysisfrom its federal counterpart is the possi-bility of taxpayer mobility across jurisdic-tions. One study (10645) explores theeffect of such mobility in the context ofstate estate taxes, and finds some evi-dence suggesting that older taxpayerswith substantial estates migrate to stateswith low estate taxes. Another studyexamines the impact on local finances ofwinning a multi-jurisdiction battle for anew plant (9844). A third study exploreshow the ease of inter-jurisdictionalmobility affects the relationship betweentax rates and revenue collections (9686).

Other Directions for ResearchThe research summarized in the four

foregoing topic areas represents only afraction of the work carried out by PublicEconomics researchers. Several otherstudies, not mentioned above, illustratethis range. Program affiliates have studiedthe design of terrorism insurance (10179,9271), the detection of teacher cheatingon behalf of students taking standard-ized tests (9413, 9414), and the effects ofdifferential tax treatment of differentsized families on fertility behavior (8845).Because the public sector is involved insome way with virtually every aspect ofmodern life in industrial democracies,researchers interested in this field have

found, and, I expect, will continue tofind, an astonishing array of researchtopics to study.

Government ServiceIn part because members of the

Public Economics Program devote their energies to studying government policies,they are frequently invited to serve in various governmental roles. Asubstantial fraction of the ResearchAssociates in the Program have devotedpart of their careers to high-level policyadvisory roles. This historical pattern hascontinued in recent years, as many pro-gram affiliates have taken a break fromtheir academic research and spent time inpolicymaking roles in Washington.Research Associate R. Glenn Hubbardserved as the Chairman of the Council ofEconomic Advisers (CEA), while HarveyRosen, Mark McClellan, and KatherineBaicker have served, or are serving, asmembers of the CEA. In addition to hisrole at CEA, Mark McClellan has alsoserved as Commissioner of the Food andDrug Administration and as Director ofthe Centers for Medicare and MedicaidStatistics. Jeffrey R. Brown has beennominated to the Social Security Advis-ory Board. I served on the President’sAdvisory Panel on Federal Tax Reform in2005. Douglas Holtz-Eakin served as theChief Economist of the Council onEconomic Advisors, and then asDirector of the Congressional BudgetOffice. Mervyn A. King was appointedGovernor of the Bank of England in2003. While some members of thePublic Economics Program make life-time commitments to participate directlyin the policy process, and they serve in avariety of policy roles, many other mem-bers have taken only a single job inWashington and then returned to theiracademic careers.


Research Summaries

The Contribution of Science and Technology to Production

James Adams*

Economists have long recognizedthat knowledge is a factor of produc-tion, and even the most important fac-tor, given its role in labor quality andthe design of capital goods. Still, it isone thing to assert a general proposi-tion and quite another to provide con-firmation of it in detail. My research ispart of a larger initiative at NBER thatseeks to provide this information. Inessence, the work is a search for tangi-ble evidence of flows of knowledge,specifically scientific and technicalknowledge, followed by an examina-tion of their effects on firms and otherinstitutions. Of course private incen-tives, internal organization, public pol-icy, and legal structure all affect the useof science and technology by firms,universities, and federal laboratories.Thus, broader aspects of moderneconomies and of modern economicsgovern the role of knowledge in pro-duction. These provide many opportu-nities for research.

The basic idea of the research is tobegin by specifying a vector of stocksof past knowledge flows in the pro-duction function. The productionfunction may specify outputs of finalor intermediate goods or it may speci-fy increments of new knowledge, such

as industrial inventions or discoveriesin basic science. From this root ideathere flow a number of subsidiaryideas. One is the reshaping of goodsproduction and the redirection ofResearch and Development (R and D)that result from the accumulation ofknowledge. A second is the distinctionbetween knowledge that is internal toan organization, and outside knowl-edge, or knowledge spillovers. A thirdtheme is the importance of limitationson flows of outside knowledge orknowledge spillovers that are imposedby absorptive capacity, human andinstitutional constraints, and the intrin-sic relevance of the information. Afourth theme is the comparable impor-tance of basic and often academic sci-ence for production, besides that ofindustrial R and D. Finally, the researchrecognizes the role that contractdesign and public policy play in delib-erate knowledge transfer betweenfirms and outside R and D performers.These in turn influence the limits ofthe firm in R and D. In pursuing eachof these themes, the design, collection,and assembly of new and high qualityeconomic data forms a critical part ofthe work.

Characterizing the Contri-bution of Knowledge

Using data on plants owned bychemical firms that span manufactur-ing, I have found that firm R and D inthe same product area as the plant is

biased towards skilled labor, so that theskill bias of firm R and D is localizedin technology space.1 In addition, firmand industry R and D shift investmentin plant capital towards equipmentcapital. This link should not be over-looked because equipment turns out tobe skill-biased. Thus the skill bias of Rand D takes place through two distinctchannels, a direct one that operatesthrough the small part of R and D thatis targeted on the plant, and an indirectand potentially much larger one thatoperates through the accumulation ofequipment capital.

The accumulation of outsideknowledge, or knowledge spillovers,could alter the rate and direction ofindustrial R and D. Using survey datafrom industrial R and D laboratories aswell as historical case studies, I findthat outside knowledge shifts R and Deffort towards learning about externalresearch and away from internalresearch.2 Similarly, in cross-equationtests I find that university R and Dincreases learning expenditures target-ed on academia, and industrial R andD increases learning expendituresdevoted to industry, but not converse-ly. These results are observationallyconsistent with the view that outsideopportunities alter the composition ofindustrial R and D, presumably inmore profitable directions, and areconsistent with the historical case stud-ies.

In all of this research, where the

* Adams is a Research Associate in theNBER's Productivity Program and is aProfessor of Economics at RensselaerPolytechnic Institute. His profile appearslater in this volume.


data allow a comparison I find statisti-cally significant effects of university sci-ence as well as industrial R and D onindustrial R and D and industrialpatents.3 Thus basic science as well asapplied research and development areimportant to industrial research.

Another set of findings concernslimits on the influence of outsideknowledge on R and D performingfirms. In work with Adam Jaffe, I findthat the effect of firm R and D on plantproductivity is amortized by geographicand technological distance. We also findthat the number of plants in a firm andindustry dilute the impact on productiv-ity of firm R and D and of industry Rand D spillovers.4 These results suggestrestrictions that may apply to economy-wide returns from spillovers. In otherwork, I find that knowledge spilloversfrom universities are more localizedthan spillovers from other firms.5 Thisfinding is curious because publishedfindings should not be localized. Thepuzzle is explained by the industry-uni-versity cooperative movement, whichencourages firms to work with localuniversities. The universities are subjectto incentives that allow firms to makeuse of their capabilities and to gainaccess to the wider world of scientificresearch. The same is not true of accessto proprietary knowledge in otherfirms.

Channels of Knowledge FlowIn work with J. Roger Clemmons

and Paula Stephan that uses data on sci-entific publications, a counterpart toindustrial patents, I also find that tech-nological distance and other factorslimit knowledge flows among universi-ties.6 In this case we explore a citationchannel of knowledge flow that is con-ditional on reading and afterwards con-tributing to the science literature. Thesize of the channel is summed up by thecitation probability. This equals actual

citations divided by potential citationswithin cells that are classified by citingand cited fields and years. We estimatecitation functions using the citationprobability as the dependent variable,where field and year effects are theindependent variables.7 Assuming thatcitations represent scientific influenceof papers cited, this probability isequivalent to a utilization rate of citedliterature by an average citing paper.Thus, our finding that the citation prob-ability is 10 to 100 times greater withinfields than between fields can be read toimply that field boundaries amount totechnological barriers, in part becauseof decreased relevance. The fact thatcross-field citation parameters resultingfrom the estimation are statistically sig-nificant in less than one fourth of thepossible cases only serves to reinforcethis conclusion. In the same paper wefind within fields that citation probabil-ities are greater from lesser universitiesto top universities than conversely, andwe find that citations to peer institu-tions increase with rank. These resultssuggest that scientific influence increas-es with quality of university depart-ments, which levels the capabilities ofdiverse institutions, but that reinforcingeffects of quality among peer institu-tions may instead sustain differences inthe capabilities of institutions.

In assessing the significance of thecitation channel it is important to con-sider alternative channels of knowledgeflow. This is despite the fact that in theliterature of industrial R and D, one keychannel of knowledge flow is found tobe the scientific literature. The citationchannel can be thought of as disem-bodied and informal, in that it does notrequire meetings or formal knowledge-sharing agreements, but it is not all-inclusive.8 In recent research with J.Roger Clemmons, Grant Black, andPaula Stephan, which uses the samedata on publications as the citationstudy, I have explored an alternative

channel of collaboration in science.9 Asan alternative to citation, collaborationis undoubtedly more costly and moretime-intensive but it offers the chanceto acquire tacit knowledge that wouldnot be available otherwise.

The paper describes trends andcross-sectional patterns in scientificteams measured by authors per paper,and in institutional collaboration, meas-ured by the location of team membersin separate institutions. The data aresteeply trended. Team size increases by50 percent over the sample period.However, counts of institutions perpaper increase by 60 percent. Counts offoreign institutions, while comparativelyrare, increase by five-fold. We concludethat team workers in science are becom-ing more geographically and even inter-nationally dispersed. This trend acceler-ates around the start of the 1990s, sug-gesting a decline in costs of collabora-tion. Our hypothesis is that the deploy-ment of NSFNET and its connectionto networks in Europe and Asia in thelate 1980s are responsible for thischange. The hypothesis is not unrea-sonable, given research and journalpublication lags.

In addition the paper explores rea-sons for teams and institutional collabo-rations. We find that more highly rankeddepartments, departments whose scien-tists have earned prestigious awards,departments with larger stocks of feder-al R and D, and departments in privateuniversities are more likely to form largeteams and to engage in institutional col-laboration. In the case of firms and for-eign institutions especially, we find thatplacement of graduate students signifi-cantly increases collaboration. Finally,the evidence suggests that scientific out-put and influence increase with teamsize and institutional collaboration.Since these factors imply an increase inthe division of labor, the results suggestthat scientific productivity increaseswith the scientific division of labor.10


Limits of the Firm in R and DConsistent with the literature of

Property Rights Economics, contractu-al design and public policy clearly influ-ence the extent to which firms turn tooutside partners for complementary Rand D assets and the extent to whichthey benefit from knowledge transfer.11

In papers that use the data on R and Dlaboratories alluded to in earlier sec-tions of this article, I have explored thisaspect of the practice of industrial Rand D.

In work with Eric Chiang andJeffrey Jensen, I find that CooperativeResearch and Development Agree-ments (CRADAs) comprise the mainchannel by which federal laboratoriesincrease patents as well as firm R andD.12 The CRADA effect survives con-trols for simultaneous equation bias, itsurvives inclusion of alternative effectsof federal laboratories on firms, and itis consistent across patents and R andD expenditure in industrial laboratories.While subject to justifiable skepticismabout the usefulness of incentives inthis setting, the results suggest thatCRADAs may be beneficial preciselybecause of the mutual effort that theyrequire of firms and government labo-ratories. In another paper with Chiangand Katara Starkey, I have found thatIndustry-University CooperativeResearch Centers (IUCRCs) also con-tribute to research productivity ofindustrial laboratories.13 Their effectentails the participation of universityresearchers in consulting, collaborationand placement with firms. BothCRADAs and IUCRCs are incentive-based policy initiatives put in placearound 1980 whose aim was to promoteknowledge transfer from the public sec-tor to private industry. The evidencecontained in the two papers suggeststhat they may have had an effect.Finally, in a third paper with MirceaMarcu I explore the behavior of R and

D sourcing in industrial laboratories.14

In this paper we find that sourcingappears to be driven by sentimentstowards Research Joint Ventures(RJVs), the option to purchase andacquire, and research with federal labo-ratories. When we turn to the effects ofsourcing, the evidence suggests that theprimary motive is that of cost-saving.This contrasts with RJVs, which con-tribute to new products, and with inter-nal research, which contributes to bothpatents and new products. All of thissuggests that deliberately shared R andD comes in different varieties designedto meet different objectives of firms.

Ongoing ResearchAlong with coworkers, I continue

to study the role of science and tech-nology in production. At present we areengaged in a study of the factors thatdetermine the speed of diffusion of sci-entific research across sectors and fieldsof science, including a comparison ofthe speed of diffusion of science withthat of patented technology. We arealso engaged in studies of the determi-nants of industrial scientific discovery,of the relationships between firmpatents and stock market value, and sci-entific research both inside and outsidethe firm. I continue to pursue long-standing interests in research contribu-tions of the university system.15 Thissystem is not only a current hotbed ofideas, but the health of the systemgoing forward may prove critical to theUnited States and other economies. Inconclusion, I am confident that thestudy of the contributions of scienceand technology to the economy willprovide grist for the economists’ millfor years and even decades to come.

1 J. Adams, “The Structure of Firm R&Dand the Factor Intensity of Production,”NBER Working Paper No. 6099, July1997, and J. Adams, “The Structure of Firm

R&D and the Factor Intensity of Production,and Skill Bias,” The Review of Econ-omics and Statistics 81 (August 1999): pp. 499–510.2 J. Adams, “Endogenous R&D Spilloversand Industrial Research Productivity,”NBER Working Paper No. 7484, January2000, revised and extended, and published as“Learning, Internal Research, andSpillovers,” The Economics ofInnovation and New Technology 15(January 2006): pp. 5–36.3 J. Adams, “Learning, Internal Research, andSpillovers,” and J. Adams, “ComparativeLocalization of Academic and IndustrialSpillovers,” NBER Working Paper No. 8292,May 2001, and J. Adams, “ComparativeLocalization of Academic and IndustrialSpillovers,” The Journal of EconomicGeography 2 (July 2002): pp. 253–78,reprinted in Clusters, Networks, andInnovation, S. Breschi and F. Malerba, eds,forthcoming, Oxford University Press.4 J. Adams and A. Jaffe, “Bounding theEffects of R&D: An Investigation UsingMatched Firm-Establishment Data,”NBER Working Paper No. 5544, April1996, and J. Adams and A. Jaffe, “Boundingthe Effects of R&D: An Investigation UsingMatched Firm-Establishment Data,”RAND Journal of Economics 27(Winter 1996): pp. 700–21.5 J. Adams, “Comparative Localization ofAcademic and Industrial Spillovers.”6 J. Adams, J.R. Clemmons, and P. Stephan,“Standing on Academic Shoulders: MeasuringScientific Influence in Universities,” NBERWorking Paper No. 10875, November 2004,forthcoming in Les Annales d’Economieet de Statistique.7 A. Jaffe and M. Trajtenberg, “InternationalKnowledge Flows: Evidence from PatentCitations,” The Economics of Innovationand New Technology 8 (1999): pp. 105–36.8 W.M. Cohen, R. Nelson, and J. Walsh,“Links and Impacts: The Influence of PublicResearch on Industrial R&D,” Manage-ment Science 48 (January 2002): pp. 1–23.9 J. Adams, G. Black, J. R. Clemmons, andP. Stephan, “Scientific Teams andInstitutional Collaborations: Evidence fromU.S. Universities, 1981–1999,” NBERWorking Paper No. 10640, July 2004, and J.Adams, G. Black, J. R. Clemmons, and P.Stephan, “Scientific Teams and Institutional


Collaborations: Evidence from U.S.Universities, 1981–1999,” ResearchPolicy 34 (April 2005): pp. 259–85. 10 J. Adams, G. Black, J. R. Clemmons, andP. Stephan, “Scientific Teams andInstitutional Collaborations: Evidence fromU.S. Universities, 1981–1999.”11 D. Mowery, “The Boundaries of the U.S.Firm in R&D,” in Coordination andInformation: Historical Perspectives onthe Organization of Enterprise, N.Lamoreaux and D. Raff, eds., Chicago:University of Chicago Press for NBER,1995.12 J. Adams, E. Chiang, and J. Jensen, “TheInfluence of Federal Laboratory R&D onIndustrial Research,” NBER Working PaperNo. 7612, March 2000, and J. Adams, E.

Chiang, and J. Jensen, “The Influence ofFederal Laboratory R&D on IndustrialResearch,” The Review of Economicsand Statistics 85 (November 2003):pp.1003–20.13 J. Adams, E. Chiang, and K. Starkey,“Industry-University Cooperative ResearchCenters,” NBER Working Paper No. 7843,August 2000, and J. Adams, E. Chiang, andK. Starkey, “Industry-University CooperativeResearch Centers,” The Journal ofTechnology Transfer 26 (January 2001):pp.73-86.14 J. Adams and M. Marcu, “R&DSourcing, Joint Ventures, and Innovation: AMultiple Indicators Approach,” NBERWorking Paper No. 10474, May 2004.15 J. Adams, “Fundamental Stocks of

Knowledge and Productivity Growth,”Journal of Political Economy 98 (August1990): pp. 673–702. See also J. Adams andZ. Griliches, “Measuring Science: AnExploration,” NBER Working Paper No.5478 (Reissued July 1997), and J. Adamsand Z. Griliches, “Measuring Science: AnExploration,” Proceedings of theNational Academy of Sciences 93(November 1996): pp.12664–70; and J.Adams and Z. Griliches, “ResearchProductivity in a System of Universities,”NBER Working Paper No. 5833,November 1996, and J. Adams and Z.Griliches, “Research Productivity in a System of Universities,” Les Annalesd’Economie et de Statistique 49/50(1998): pp.127–62.

Foreign Direct Investment Behavior of Multinational Corporations

Bruce A. Blonigen*

There is increasing recognitionthat understanding the forces of eco-nomic globalization requires lookingfirst at foreign direct investment (FDI)by multinational corporations (MNCs):that is, when a firm based in one coun-try locates or acquires production facil-ities in other countries. While realworld GDP grew at a 2.5 percentannual rate and real world exportsgrew by 5.6 percent annually from1986 through 1999, United Nationsdata show that real world FDI inflowsgrew by 17.7 percent over this sameperiod! Additionally, MNCs mediatemost world trade flows. For example,Bernard, Jensen, and Schott find that90 percent of U.S. exports and importsflow through a U.S. MNC, with rough-

ly 50 percent of U.S. trade flows occur-ring between affiliates of the sameMNC, or what is termed “intra-firmtrade”.1

Despite the obvious importanceof FDI and MNCs in the world econ-omy, research on the factors thatdetermine FDI patterns and theimpact of MNCs on parent and hostcountries is in its early stages. Themost important general questions are:what factors determine where FDIoccurs, and what impacts do thoseMNC operations have on the parentand host economies? As I discuss in arecent survey of the empirical literatureaddressing the first question — thedeterminants of FDI decisions — theanswers are not straightforward.2 Inparticular, the literature has shown thatwe cannot simply conclude that factorssuch as exchange rates or tax policieshave an unambiguous general impacton FDI patterns. Instead, meaningfulinsights come from developing

hypotheses about, say, when a factorshould matter for FDI, or even just aparticular form of FDI, and then find-ing creative ways to test these hypothe-ses in the data.

Exchange Rates and FDI One good example of this is the

effect of exchange rate movements onFDI. For years, the conventional theo-ry was to compare FDI to bonds, forwhich exchange rate movements donot affect the investment decision. Adepreciation of the currency in thehost country reduces the amount offoreign currency needed to purchasethe asset, but it also reduces the nomi-nal return one receives in the foreigncurrency. Thus, the rate of return forthe foreign investor does not change.Empirical studies of FDI seemed toconfirm this, often finding insignifi-cant effects of exchange rates. In con-tradiction to this, the popular press

* Blonigen is a Research Associate in theNBER's Program on International Trade andInvestment and the Knight Professor of SocialScience at the University of Oregon. His profileappears later in this issue.


often points to host-country exchangerate depreciations as a contributing fac-tor to inward foreign investmentbooms, and worries about the selling ofkey national technological assets.

I find a resolution to this puzzle byconsidering FDI that involves firm-spe-cific assets (such as patents or manage-rial skills) — the type of assets previousliterature established as crucial to for-mation of MNCs and FDI.3 Such assetsare typically intangible and easily trans-ferred across a firm’s operations. Thus,the purchase prices of such assetsthrough FDI are in the host-country’scurrency, but returns can be generatedanywhere the firm operates and are notnecessarily tied to the home country’scurrency. This means that host-countrycurrency depreciations theoretically canlead to increased acquisition of FDI,particularly of firms that have firm-spe-cific assets. This hypothesis is stronglyconfirmed for a panel of acquisitions ofU.S. firms by Japanese and Germanfirms and provides evidence for thenotion in the popular press that curren-cy depreciations ease foreign firms’ pur-chases of U.S. host-country technologi-cal assets.

Taxes and FDIAnother factor that the literature

finds does not affect FDI in a straight-forward manner is tax policy. MNCs arepotentially subject to taxation in boththe host and parent country. However,most parent countries have policies toreduce or eliminate double taxation oftheir MNCs. James R. Hines, Jr. and co-authors have shown that the way inwhich parent countries reduce doubletaxation on their MNCs (for example,allowing credits or deductions) can havequite different implications for FDIactivity.4

Many countries also have negotiat-ed bilateral investment treaties (BITs) tomutually reduce withholding taxes on

MNCs based in the other country. TheOrganisation for Economic Co-opera-tion and Development (OECD) hasbeen a big advocate of BITs as a way toenhance FDI across member countries.Others contend that BITs are mainlyintended to share tax informationacross countries in order to deter taxevasion and to reduce administrativecosts and, thus, should have little, oreven negative, effects on FDI flows.5Ron B. Davies and I examine whetherthe empirical evidence suggests thatsuch treaties increase FDI flows acrossnations, as the OECD and many econ-omists presume.6 In separate studies, weexamine the evidence for the U.S. andfor OECD BITs, respectively, in paneldata that span a variety of bilateralcountry pairs over time. Across thesevarious samples and numerous specifi-cations, we find little evidence thatthese BITs increase FDI activity, a sur-prising result in light of OECD promo-tion of these treaties.

Trade Protection and FDIThe notion that trade protection

encourages FDI is folk wisdom foreconomists, so much so that it is rarelyexamined empirically. But my researchinto this relationship has also yieldedsurprises. In a study examining all U.S.antidumping trade protection actionsfrom 1980 through 1995, I find thatFDI responses to these trade actions(tariff-jumping FDI) occur only forfirms with previous experience asMNCs.7 Most firms facing such tradepolicies (many from developing coun-tries) have no such experience and donot respond with FDI. Instead, thesefirms must face either significantantidumping duties or go through thecostly process of raising U.S. prices andrequesting recalculations of the duties.8For domestic firms, whether foreignfirms tariff-jump the antidumpingduties matters significantly. Work with

Tomlin and Wilson finds that domesticfirms experience a 3 percent increase inexpected discounted profitability fromantidumping duties unless the foreignfirms subject to the duties decide to tar-iff-jump, in which case the domesticfirms do not experience any increase.9,10

Information and FDIAn almost unexplored issue in the

literature has been the role of informa-tion on FDI decisions. FDI requiressubstantial fixed costs of identifying anefficient location, acquiring knowledgeof the local regulatory environment,and coordination of suppliers. Thus,access to better information aboutsome host countries may make FDI tothat location more likely. Ellis, Fausten,and I find an interesting avenue forinvestigating this hypothesis usinginformation on Japanese industrialgroups called keiretsu.11 Horizontal keiret-su are groups of firms across a widerange of industries, typically centeredaround a main bank that owns signifi-cant shares in these firms. A number ofstudies have focused on the potentiallyfavorable financing received by keiretsufirms from their main bank as oneimpetus for greater investment by thesefirms, including FDI — but the evi-dence is mixed on this. However, themajor firms in a keiretsu also get togeth-er on a regular basis in what are termedPresidential Meetings and presumablyshare information more than otherfirms would. My work with Ellis andFausten examines whether this infor-mation affects FDI choices, by estimat-ing how much prior-year FDI by mem-bers of a firm’s keiretsu in a particularhost country increases the likelihoodthat the firm will also choose that coun-try for its FDI. We find that prior-yearinvestment by a firm in the same keiret-su will raise a firm’s probability of locat-ing an investment in that same hostcountry by about 20 percent.


A related paper with Woosterexamines whether U.S. firms increaseoverseas investments when a new CEOwho is foreign-born takes over.12 Ourexamination of CEO turnover amongFortune 500 firms in the 1990s doesshow evidence of significant increasesin FDI when a “foreign” CEO takesover. It is difficult to disentanglewhether such an effect is attributable tobetter information of foreign marketsby the foreign CEO or to different per-sonal preferences influenced by a lessU.S.-centric perspective. Regardless, theresults suggest that there are likely otherimportant factors behind FDI patternsthan the standard economic ones sooften mentioned in the literature.

Estimating Long-RunGeneral-EquilibriumDeterminants of FDI

Much of the literature described tothis point motivates analysis with partialequilibrium models of individual firm-level FDI decisions. But we also want tohave empirical specifications of FDIthat are grounded in theory and that doa good job of explaining FDI patternsacross the world. Researchers looking atworld FDI patterns have generally usedvariations of a gravity framework tomodel FDI, specifying parent- andhost-country GDPs along with distanceas core determinants of FDI. Thesemodels seemingly do well to describeFDI patterns statistically, but whileAnderson and van Wincoop have solid-ified an appropriate gravity specificationas theoretically valid for trade patterns,it is not clear this is true for FDI pat-terns.13

Of course, deriving a theoreticallybased empirical specification of FDI isa fairly complicated problem. Generalequilibrium theoretical models ofMNCs and their FDI activities only firstbegan to be developed in the mid-1980swith Markusen’s development of a hor-

izontal model of FDI where an MNCreplicates its process across multiplecountries to avoid trade frictions, andHelpman’s vertical MNC model wherefirms locate their production processabroad to take advantage of lower fac-tor costs.14 A recent important step byCarr, Markusen, and Maskus (CMM)was estimation of empirical specifica-tions of FDI based on general equilib-rium models of MNCs.15 Their workshows that other factors missing fromgravity-based FDI specifications, partic-ularly factor endowment differences,are important for explaining FDI pat-terns.

In recent work with co-authors Ihave explored the central question ofhow well these specifications actually fitthe real-world data we observe. Theempirical specification estimated byCMM was a starting point in thisresearch, since its inclusion of endow-ment differences clearly outperforms astandard gravity equation of FDI. Ininitial work with the model, Davies,Head, and I found that the CMM modelhad a specification of endowment dif-ferences that was not consistent withthe theory. Once corrected, the modelno longer provides evidence that verti-cal FDI motivations are very importantin overall FDI flows between coun-tries.16 Work with Davies and Wangshows that specification error goesbeyond this with not only the CMMmodel, but also with the gravity specifi-cation.17 Data on FDI between coun-tries are highly skewed, with very largeactivity between developed countriesand small or even no activity for verysmall countries. We show that even afterlogging variables, adding country fixed-effects, and splitting samples into devel-oped countries versus less-developedcountries, one is still not guaranteed ofhaving normally distributed error terms.In other words, finding an appropriatespecification that effectively models thesubstantial heterogeneity in FDI activity

across countries is still an open issue.Until this is resolved, using these mod-els as control variables in studies ofhow new factors of interest affect FDIcan be misleading.

An additional concern is that MNCmodels typically use a two-countryframework and empirical FDI specifica-tions use bilateral FDI data. Thisassumes that FDI decisions to differentmarkets are independent. There are anumber of reasons to think this maynot be true. For example, U.S. firmsmay prefer to locate FDI in one coun-try and then export to neighboringcountries (export-platform FDI). Inthis case, more FDI in a particular hostcountry would mean less in neighboringones. Alternatively, U.S. firms may havevertical production relationshipsbetween affiliates such that more FDIin a country will naturally be associatedwith more in neighboring ones becauseof production externalities. Davies,Naughton, Waddell, and I explore thisby explicitly modeling spatial interde-pendence in empirical estimation ofU.S. FDI patterns.18 We find that spatialinterdependence shows up significantlyin the data, although the nature of thesespatial relationships is strongly affectedby the particular geographic features ofthe sample of countries one chooses toexamine. However, our finding that thecoefficients on the standard controlvariables in FDI studies are hardlyaffected by including these spatial con-siderations is relatively good news forprevious work using these empiricalspecifications.

ConclusionThe study of FDI and MNCs is

both fascinating and important forunderstanding economic globalization.There has been substantial progress inthe literature in the past couple ofdecades, but it is complicated enoughthat, in many ways, we are still in the


process of uncovering what we don’tknow. I am excited to work on fillingmore gaps in our understanding in myfuture research efforts.

1 A.B. Bernard, J.B. Jensen, and P.K. Schott,“Importers, Exporters and Multinationals: APortrait of the Firms in the U.S. that TradeGoods,” NBER Working Paper No. 11404,June 2005.2 B.A. Blonigen, “A Review of the EmpiricalLiterature on FDI Determinants,” NBERWorking Paper No. 11299, May 2005, andforthcoming, Atlantic Economic Journal.3 B.A. Blonigen, “Firm-Specific Assets andthe Link Between Exchange Rates andForeign Direct Investment,” AmericanEconomic Review, 87(3), June 1997, pp.447–65. 4 For example, see J.R. Hines, “Altered States:Taxes and the Location of Foreign DirectInvestment in America,” NBER WorkingPaper No. 4397, May 1997, and AmericanEconomic Review, 86(5), December 1996,pp. 1076–94, and M.A. Desai, C.F. Foley,and J.R. Hines, “Foreign Direct Investment ina World of Multiple Taxes,” NBERWorking Paper No. 8440, August 2001, andJournal of Public Economics, 88(12),December 2004, pp. 2727–44. 5 For example, see T. Dagan, “The TaxTreaties Myth,” New York UniversityJournal of International Law andPolitics, Summer 2000, pp.939–96.6 B.A. Blonigen and R.B. Davies, “TheEffects of Bilateral Tax Treaties on U.S.FDI Activity,” International Tax andPublic Finance, 11(5), September 2004,pp. 601–22, and B.A. Blonigen and R.B.Davies, “Do Bilateral Tax Treaties PromoteForeign Direct Investment?” NBERWorking Paper No. 8834, March 2002, andHandbook of International Trade,Volume II: Economic and LegalAnalysis of Laws and Institutions, J.Hartigan, ed., Blackwell Publishers, 2005.7 B.A. Blonigen, “Tariff-jumping Antidump-ing Duties,” NBER Working Paper No.7776, July 2000, and Journal ofInternational Economics, 57(1), June2002, pp. 31–50.8 B.A. Blonigen, “Evolving Discretionary

Practices of U.S. Antidumping Activity,”NBER Working Paper No. 9625, April2003, and, forthcoming, Canadian Journalof Economics, documents the rapidly risingtrend in U.S. antidumping duties and thesources of this trend. B.A. Blonigen and S.E.Haynes, “Antidumping Investigations and thePass-Through of Exchange Rates andAntidumping Duties,” NBER WorkingPaper No. 7873, October 1999, andAmerican Economic Review, 92(4),September 2002, pp. 1044–61, and B.A.Blonigen and J.-H. Park, “ Dynamic Pricingin the Presence of Antidumping Policy:Theory and Evidence,” NBER WorkingPaper No. 8477, September 2001, andAmerican Economic Review, 94(1),March 2004, pp. 134–54, address the eco-nomics of firms’ strategic pricing decisions inthe face of antidumping duties.9 B.A. Blonigen, K. Tomlin, and W.W.Wilson, “Tariff-jumping FDI and DomesticFirms’ Profits,” NBER Working Paper No.9027, June 2002, and Canadian Journal ofEconomics, 37(3), August 2004, pp.656–77.10 A related issue is how FDI may affect tradeprotection policies (that is, reverse causality),which I address with co-authors in B.A.Blonigen and R.C. Feenstra, “ProtectionistThreats and Foreign Direct Investment,”NBER Working Paper No. 5475, March1996, and in Effects of U.S. TradeProtection and Promotion Policies, R.C.Feenstra, ed.,Chicago: University of ChicagoPress, 1997, pp. 55–80, and B.A. Blonigenand D.N. Figlio, “Voting for Protection: DoesDirect Foreign Investment Influence LegislatorBehavior?” American Economic Review,88(4), September 1998, pp. 1002–14.11 B.A. Blonigen, C.J. Ellis, and D. Fausten,“Industrial Groupings and Foreign DirectInvestment,” Journal of InternationalEconomics, Vol. 65(1), January 2005, pp.75–91. (An earlier version was circulated as“Industrial Groupings and Strategic FDI:Theory and Evidence” NBER WorkingPaper No. 8046, December 2000). 12 B.A. Blonigen and R.B. Wooster, “CEOTurnover and Foreign Market Participation,”NBER Working Paper No. 9527, March2003.13 J.E. Anderson and E. van Wincoop,

“Gravity with Gravitas: A Solution to theBorder Puzzle,” NBER Working Paper No.8079, January 2001, and AmericanEconomic Review, 93(1), March 2003,pp. 170–92.14 J.R. Markusen, “Multinationals, Multi-Plant Economies, and the Gains from Trade,”Journal of International Economics,16(3–4): pp. 205–26, and E. Helpman, ASimple Theory of International Trade withMultinational Corporations,” Journal ofPolitical Economy, 92(3), pp. 451–71.15 D.L. Carr, J.R. Markusen, and K.E.Maskus, “Estimating the Knowledge-CapitalModel of the Multinational Enterprise,”NBER Working Paper No. 6773, October1998, and American Economic Review,91(3), June 2001, pp. 693–708, and J.R.Markusen, and K.E. Maskus, “Discrimi-nating Among Alternative Theories of theMultinational Enterprise,” NBER WorkingPaper No. 7164, June 1999, and Review ofInternational Economics, 10(4),November 2002, pp. 694–707.16 B.A. Blonigen, R.B. Davies, and K. Head,“Estimating the Knowledge-Capital Model ofthe Multinational Enterprise: Comment,”NBER Working Paper No. 6773, October1998, and American Economic Review,93(3), June 2003, pp. 980–94. 17 B.A. Blonigen and R.B. Davies, “TheEffects of Bilateral Tax Treaties on U.S.FDI Activity,” International Tax andPublic Finance, 11(5), September 2004,pp. 601-22, and B.A. Blonigen and M.Wang, “Inappropriate Pooling of Wealthyand Poor Countries in Empirical FDIStudies,” NBER Working Paper No.10378, March 2004, and Does ForeignDirect Investment Promote Develop-ment? T.H. Moran, E.M. Graham, and M.Blomstrom, eds., Institute for InternationalEconomics, April 2005, pp. 221–44. 18 B.A. Blonigen, R.B. Davies, G.R.Waddell, and H.T. Naughton. “FDI inSpace: Spatial Autoregressive Relationships inForeign Direct Investment,” NBER WorkingPaper No. 10939, December 2004, and“Spacey Parents: Spatial AutoregressivePatterns in Inbound FDI,” NBER WorkingPaper No. 11466, July 2005.


Two recent anniversaries have put aspotlight on the economic history ofrace-related public policy in the UnitedStates — the fiftieth anniversary of theSupreme Court’s Brown v. Board ofEducation decision and the fortiethanniversary of the Watts Riot in LosAngeles. The Brown decision was a land-mark in the mid-century reorientation ofrace-related policy, as the machinery ofgovernment slowly responded to theimperatives of the Civil RightsMovement. The Watts Riot, in contrast,marked the onset of a wave of civil dis-turbances that broke out in predomi-nantly black neighborhoods across thecountry. Although they were fundamen-tally different manifestations of African-American discontent, the Brown case andthe 1960s riots have two things in com-mon: first, they often serve as points ofdeparture in discussions of race andlabor market, housing market, and edu-cational disparities; second, whatevertheir political or symbolic significance,scholars have yet to reckon fully theireconomic significance.

Much of my work has attempted tomeasure the effects of such events andto describe the underlying political econ-omy and historical forces that con-tributed to their occurrence. This isundertaken with the overarching goal ofbuilding a more comprehensive andquantitative story of the economics ofrace in twentieth century America. Inthis research summary, I describe specif-

ic work on the evolution of racial dispar-ities in educational outcomes, the politi-cal economy and impact of changes inrace-specific employment and housingpolicy, and racial disparities in housingmarket outcomes, including assessmentsof how severe riots affected the cities inwhich they occurred.

Race and SchoolingIn 1860, approximately 90 percent

of African-Americans were slaves, andfew slaves (perhaps 10 percent) learnedto read and write at even a minimal levelof competence. Throughout the South,it was illegal to teach slaves to read andwrite; consequently, African-Americansentered into the post-Emancipation peri-od with very little exposure to formalschooling. The literacy rate gap betweenblacks and whites born between 1800and 1860 (and still alive in 1870) wasapproximately 70 percentage points.Robert A. Margo and I use micro-levelcensus data, a simple model of parents’incentives to invest in their children’sschooling, and historical sources todescribe the long-run process of racialconvergence in schooling attainmentfrom 1870 onward.1 Despite imperfec-tions and limitations of the data, it isclear that the key mechanism driving theconvergence was “cohort replacement”— new generations of African-Americans entered the labor force withmore and better schooling (relative towhites) than older generations that exit-ed the labor force. There was nothingautomatic about this process, especiallyin the 1890-1930 period when the disen-franchisement of southern blacksenabled administrators to ratchet up the

quality of white schools at the expenseof black ones, and as the high schoolmovement took off in the North (wherefew blacks lived).2 In fact, there appearsto have been some racial divergence inyears of schooling for some birthcohorts in this period. But the incentivesfor investing in children’s schooling werestrong (despite labor market discrimina-tion), and the overall post-1870 story isdominated by a theme of black-whiteconvergence. The literacy rate gapamong those born from 1870 to 1909was about 20 percentage points, and forthe 1910-14 birth cohort to the 1950-4birth cohort, the racial difference in aver-age grades of schooling fell from threeto less than one. The work highlights theimportance of intergenerational factorsin the transmission of human capital,and it provides an important backdropto current debates about racial differ-ences in test scores and educationalattainment.3

A subsequent paper, co-authoredwith Orley Ashenfelter and Albert Yoon,attempts to set the Supreme Court’sBrown v. Board decision in the context ofthe history described above.4 Resourcesfor black and white schools in the Southbegan to equalize about two decadesbefore the 1954 Brown decision, but itwas not until the late 1960s that southernschools truly desegregated. The paperaddresses two main questions. First, afterestimating the labor market returns toschool quality for southern-born blackmen, we ask how much more would theyhave earned (in 1970) if they had attend-ed schools with the same measurablecharacteristics as white schools in theirbirth state? For the 1920s birth cohort,we estimate a 6 to 9 percent earnings

Race and Twentieth-Century American Economic History

William J. Collins*

* Collins is a Research Associate of theNBER's Development of the AmericanEconomy Program and an Associate Professorof Economics at Vanderbilt University. Hisprofile appears later in this issue.


loss. Second, given that school desegre-gation in the South occurred fairly sud-denly, is there evidence that pre andpost-desegregation cohorts of southern-born black students fared differently inlabor markets or in terms of educationalattainment (in 1990)? With numerouscaveats attached to the interpretation,the answer is “yes”. Relative to same-aged non-southern-born blacks, thepost-desegregation southern-born co-horts earned more than the pre-desegre-gation southern-born cohorts, by about10 percent.

The Political Economy andEffects of Early Anti-Discrimination Laws

World War II catalyzed the CivilRights Movement. Because of wartimeproduction exigencies, African-American leaders had more political leverage thanever before. As labor markets tightened,African-American workers were in rela-tively high demand; still, they were initial-ly excluded from high-paying defense-industry jobs. A. Philip Randolph, aprominent black labor leader, demanded(by threatening a march on Washington)that President Roosevelt issue an executive order to outlaw discriminationin defense work. The President’s Fair Employment Practice Committeeattempted to enforce the first widelyapplicable anti-discrimination policy,thereby opening some new employmentopportunities for black workers and pro-viding a model regulatory agency forfuture anti-discrimination initiatives.5

The policy and the Committee expiredwhen the war ended, but the drive to leg-islate similar policies and committees atthe state and federal level continued.

At the federal level, the Civil RightsAct of 1964, the Voting Rights Act of1965, and the Fair Housing Act of 1968were the culmination of the politicalstruggle to advance such legislation. Butlong before these milestones, race-spe-cific policy changed rapidly at the state

level. The unevenness of the diffusion ofanti-discrimination policy providesopportunities to study both the politicaleconomy and the effects of such policiesbefore federal coverage applied a compar-atively uniform standard to all places atthe same time.

To explore the political economythat facilitated (or hindered) the spreadof fair employment and fair housinglaws, I combined historical sources andhazard models.6 In short, I learn thatthroughout the period under study,African-Americans were a relativelysmall and poor segment of the non-southern population. Nonetheless, thelegislation gradually moved forwardbecause the efforts of black politicalgroups (such as the NAACP) werestrongly reinforced by labor unions (par-ticularly the CIO) and Jewish groups.The econometric estimates and historicalaccounts of state-level legislative cam-paigns complement one another in thisinterpretation. The hazard model coeffi-cients, which can be used to project thelikelihood of the adoption of anti-dis-crimination laws, also confirm thenotion that federal intervention was crit-ical in the South.

But did the sub-federal anti-discrim-ination policies make any real differencefor black workers and households? Theresults from detailed analyses of individ-ual-level census data are mixed. I findthat black workers, especially women,residing in states that adopted fairemployment laws in the 1940s had largerimprovements in their labor market out-comes during the 1940s than black work-ers in similar states that did not adoptfair employment laws. But I find no suchevidence for black workers in states thatadopted fair employment laws in the1950s.7 In a separate paper on fair hous-ing laws and housing markets in the1960s, I find little evidence of a signifi-cant positive effect on the quality ofhousing enjoyed by black households oron the level of residential segregation.8

Although the state fair housing lawswere usually somewhat stronger in cov-erage and enforcement provisions thanthe federal Fair Housing Act of 1968,they were still considered by many con-temporary observers to be too weak andtoo blunt to make a big difference. Theresults are consistent with that sugges-tion.

Home Ownership, HousingValues, and Riots

A series of co-authored papersexplores the economic history of race,residential segregation, home ownership,and housing values.9 The racial gap in thehome ownership rate (by householdheads) was nearly the same in 2000 as itwas in 1900, approximately 25 percent-age points. Around mid-century, the gapwidened as whites rapidly increased theirrate of home ownership and as blacksmoved to central cities (where ownershiprates were low), but between 1960 and1980 the gap narrowed. Even so, theownership gap remains large, and in2000 approximately half of the gapcould not be accounted for by racial dif-ferences in income, education, location,or household composition. This isapproximately the same size as the“unexplained” portion of the gap in1940. In a separate paper, Margo and Ifind that there was considerable black-white convergence in the ratio of meanvalues of owner-occupied housingbetween 1940 and 1970 (from about 0.36to 0.60) but, again, there has been littlechange since. It is notable that the vastmajority of black-white convergence inownership and housing values occurredbefore the federal Fair Housing Act andrelated anti-discrimination policies andbefore large numbers of black familiesmoved to the suburbs.

The unprecedented wave of riotsthat rolled through black neighborhoodsin the mid- to late-1960s looms large inthe literature on race, housing, and cities,but few studies attempt to measure the


riots’ economic impact. In two papers,Margo and I set out to measure theeffect of the riots on the labor marketoutcomes and owner-occupied propertyvalues of African-Americans.10 Most ofour analysis focuses on cross-city regres-sions of changes in labor market out-comes or property values on measures ofriot severity, pre-riot trends, and severalcity-level characteristics. Instrumentalvariable estimates that exploit exogenousvariation in the weather around the timeof Martin Luther King’s murder and incity government structure provide analterative perspective on the riots’ effects.When possible, we also examine patternsof change at the census tract level andusing individual-level data. Nearly all ofthe evidence suggests that the riots hadnegative and long-lasting effects (until atleast 1980) on the median value of black-owned residential property and smaller,but nontrivial, effects on the medianvalue of all residential property. For the1960s, the base results suggest approxi-mately a 15 percent decline in the valueof black-owned property in cities thathad severe riots compared to those thatdid not. Our estimates of the effects onlabor market outcomes are more mixed,but on the whole they suggest a signifi-cant negative riot effect on black incomeand employment. For example, the baseresults suggest approximately a 10 per-cent decline in median black familyincome in cities that had severe riotscompared to others.

New WorkTwo new projects will follow close

on the heels of those described above,though with less focus on race-specificissues. First, I hope to study the long-runeconomic impact of early urban renewaland slum clearance projects (particularlyin the 1950s and 1960s), which is cur-rently unknown. Like much of the workdescribed above, anecdotal impressionshave outstripped systematic analyses of

the policy effects thus far. Second, in aco-authored paper with Martha Bailey Idemonstrated the importance of therapid decline in household serviceemployment, especially for black womenand especially after 1940, a decline thatcoincided with a dramatic reorganizationof intra-household production and a risein married women’s labor force partici-pation.11 Currently, Bailey and I are col-lecting data on electrification, householdappliances, domestic servants, andwomen’s fertility and labor market out-comes to shed light on the early-to-midtwentieth century connections betweenwomen’s work in the home and work inthe market.

1 W.J. Collins and R.A. Margo, “HistoricalPerspectives on Racial Differences in Schoolingin the United States,” NBER Working PaperNo. 9770, June 2003, forthcoming in theHandbook of the Economics ofEducation, E. Hanushek and F. Welch eds.New York: North-Holland.2 C. Goldin, “America’s Graduation fromHigh School,” Journal of EconomicHistory 58 (1998): pp. 345–74.3See, for example, D. Neal, “Why HasBlack-White Skill Convergence Stopped?”NBER Working Paper No. 11090, January2005.4 O. Ashenfelter, W.J. Collins, and A. Yoon,“Evaluating the Role of Brown v. Board ofEducation in School Equalization,Desegregation, and the Income of AfricanAmericans,” NBER Working Paper No.11394, June 2005, forthcoming in AmericanLaw and Economics Review.5 W.J. Collins, “Race, Roosevelt, and WartimeProduction: Fair Employment in World WarII Labor Markets,” American EconomicReview 91 (2001): pp. 272–86; “African-American Economic Mobility in the 1940s:A Portrait from the Palmer Survey,” Journalof Economic History 60 (2000):pp.756–81; and M.J. Bailey and W.J.Collins, “The Wage Gains of African-American Women in the 1940s,” NBERWorking Paper No. 10621, July 2004. 6 W.J. Collins, “The Political Economy ofState-Level Fair-Employment Laws,1940–1964,” NBER Historical Working

Paper No. 128, June 2000, andExplorations in Economic History 40(2003): pp. 24–51; and W.J. Collins, “ThePolitical Economy of State Fair-HousingLaws Prior to 1968,” NBER WorkingPaper No. 10610, July 2004, forthcoming inSocial Science History.7 W.J. Collins, “The Labor Market Impact ofState-Level Anti-Discrimination Laws,1940-1960,” NBER Working Paper 8310,May 2001, and Industrial and LaborRelations Review 56 (2003): pp. 244–72.8 W.J. Collins, “The Housing Market Impactof State-Level Anti-Discrimination Laws,1960-1970,” NBER Working Paper No.9562, March 2003, and Journal of UrbanEconomics 55 (2004): pp.534–64.9 W.J. Collins and R.A. Margo, “Race andHome Ownership: A Century-Long View,”NBER Working Paper No. 7277, August1999, and Explorations in EconomicHistory 38 (2001): pp. 68–92; “ResidentialSegregation and Socioeconomic Outcomes:When Did Ghettos Go Bad?” EconomicsLetters 69 (2000): pp. 239–43; and “Raceand the Value of Owner-Occupied Housing,1940–1990,” NBER Working Paper No.7749, June 2000, and Regional Scienceand Urban Economics 33 (2003): pp.255–86. 10 W.J. Collins and R.A. Margo, “The LaborMarket Effects of the 1960s Riots,” NBERWorking Paper No. 10243, January 2004,and in Brookings-Wharton Papers onUrban Affairs 2004, W. Gale and J. Packeds. Washington, DC: Brookings Institution,2004, pp. 1–34; and “The EconomicAftermath of the 1960s Riots in AmericanCities: Evidence from Property Values,”NBER Working Paper No. 10493, May2004.11 M.J. Bailey and W.J. Collins, “The Wage Gains of African-American Women inthe 1940s,” NBER Working Paper No.10621, July 2004. For related work, see J. Greenwood, A. Seshadri, and G.Vandenbroucke, “The Baby Boom and BabyBust,” American Economic Review (95)1, March 2005, pp. 183–207; W.J. Collinsand R.A. Margo, “Historical Perspectives onRacial Differences in Schooling in the UnitedStates,” NBER Working Paper No. 9770,June 2003, forthcoming in the Handbook ofthe Economics of Education, E.Hanushek and F. Welch eds. New York:North-Holland.


Globalization is probably one of themost overused words in economics, as itis in many other realms of academic andpublic debate. Nonetheless, it cannot beavoided, if only because an understand-ing of the modern world requires us toconfront it. Economically, its potentialbenefits seem all too apparent: for exam-ple, the fast growing industrializingeconomies of Asia are well connected toglobal markets for goods and capital.Conversely, no economically isolatedcountry has prospered. As UN SecretaryGeneral Kofi Annan has pointed out:“The main losers in today’s very unequalworld are not those that are too exposedto globalization, but those who have beenleft out.”

My recent research has focused onthe causes and consequences of global-ization, and is based on an interdiscipli-nary approach that straddles internation-al economics, economic growth, and eco-nomic history. Methodologically, an his-torical approach has appeal because theglobal “economic laboratory” providesdata not only across space (for cross-country comparisons) but also acrosstime (from previous centuries to thepresent era). Historical data contain morevariation than contemporary data alone,providing a wealth of information to beexploited. An emerging sub-field of NewComparative Economic History is devot-ed to exploring relationships in the very

long run in the economic environment(institutions, regimes, policies, and so on)and economic outcomes (growth, infla-tion, trade, capital movements, and soon).

In that vein, I have been working toaddress several important questions thathelp us understand economic globaliza-tion over the last 100–150 years, allowingus to understand the economic outcomesof today with a deeper perspective. Inthis research summary I highlight twostrands of this work: the evolution ofglobal capital markets and the evolutionof world trade. These topics address suchissues as: how can we measure the extentof globalization? What explains the riseand fall of globalization in different erasand in different countries? What are thecosts and benefits of globalization?

The Ebb and Flow of GlobalCapital

The forces of economic globaliza-tion appear particularly strong at present,but economic historians have been atpains to point out that we are now livingin the second era of globalization, notthe first. The first stretched from rough-ly 1870 until the start of World War I in1914 and saw unprecedented integrationin international market for goods, capital,and labor. Since a key issue for the intel-lectual enterprise of New ComparativeEconomic History is whether the pastcan provide useful lessons for the pres-ent, we have first to answer the questionof whether this past era in any wayresembles the present. A first challenge isto assess quantitatively when and wherethe extent of market integration in thepast bore any resemblance to that seen

today.Much of my own research, including

a large project in collaboration with myfellow NBER Research AssociateMaurice Obstfeld, has been concernedwith this question of measuring marketintegration over time, with a focus onglobal capital markets.1 There is noagreed upon method for evaluating mar-ket integration, although we have madesome progress recently using nonlineartheoretical and empirical models to betterestimate transactions costs in marketsusing high-frequency price data. Formost applications both price and quanti-ty criteria remain relevant. Each havetheir weaknesses — quantities may flow,and prices may converge, between loca-tions despite large obstacles — and aux-iliary assumptions and information mustbe carefully considered using either crite-rion. Yet what we find, broadly, is thatglobal capital markets were just asimpressive in their degree of integrationa century ago as they are today. Somevery simple quantity criteria can sum upthe story.

For example, we can look simply atthe ratio of the stock of foreign invest-ment in the world to global GDP. Plottedover time, this series has a distinctiveshape. It rose dramatically from 1870 to1914, from 7 percent to 18 percent. From1914 to 1950 it fell precipitously to just 5percent. It rose slowly but stayed fairlylow through the 1980s, and it then surgedquickly in the last two decades of thetwentieth century from 25 percent to 92percent. The data suggest that we haveindeed lived through two eras of global-ization, and using this yardstick, the inter-national movement of capital one hun-dred years ago was no less impressive

Globalization and New Comparative Economic History

Alan M. Taylor*

* Taylor is a Research Associate in theNBER's Programs on the Development of theAmerican Economy, International Trade andInvestment, and International Finance andMacroeconomics, and a professor of economicsat the University of California, Davis. Hisprofile appears later in this issue.


than that witnessed today. The data alsoreveal two major reversals in the twenti-eth century: a steep decline in capitalmovement in the interwar years and asteep rise in the 1980s, creating a distinc-tive “U-shape” pattern when these dataare plotted.

More formal tests are possible. Forexample, turning from stock data to flowdata, we can look at the correlation ofsaving and investment rates across coun-tries and across time. As the seminalwork of Martin S. Feldstein and CharlesY. Horioka points out, a small openeconomy need not see any correlation ofdomestic investment and saving in theshort run, so any correlation between thetwo may be considered prima facie evi-dence of capital market frictions.2 We cangain some preliminary insight if we applythis methodology across time and space,using annual data from 1870 to the pres-ent. We suppose that investment is drivenby where the best profit opportunitiesare, at home or abroad; saving is drivenby consumption choices, which thehousehold can in principle de-link fromfirm investment choices; and the differ-ence between saving and investment isthe current account. We need only to addthe caveat that, in the long run, the twomust be correlated: the long-run budgetconstraint of the economy dictates that“on average” the current account be inbalance, allowing for initial wealth.

Econometric results show that thecorrelation between saving and invest-ment almost never goes to zero —indeed, the long-run budget constrainttends to keep the measure between aminimum of 0.5 and a maximum of 1 forreasonable model simulations under awide range of parameters. Yet this rangestill provides a useful yardstick. Sureenough, we find correlations in the dataclose to the low of 0.5, implying low fric-tions, in both eras of globalization: a cen-tury ago and today. We find high correla-tions close to the high of 1, implying highfriction, in between: during the interwar

period and the Bretton Woods era (thelatter being the period studied byFeldstein and Horioka). The familiarstory of two globalizations — and thesame “U-shape” — emerges again.

The “U-shape” pattern, which recursin many other tests based on a variety ofdata and empirical methodologies, alsoconforms to the broad contours of thehistory of macroeconomic policymakingin the world’s major economies that arethe main focus of the study (quite differ-ent patterns apply to developing coun-tries). In the two eras of globalization,capital controls were notably absent andwere typically frowned upon; in between,at the bottom of the “U,” capital controlsbecame prevalent and came to be judgedas the norm. How and why the history ofpolicymaking followed these twists andturns then becomes an important ques-tion.

A central concept in internationalmacroeconomics presents itself as a can-didate explanation: the “trilemma.” Thetrilemma posits that economic policycannot simultaneously achieve threegoals — a fixed (or even managed)exchange rate, which may be desired forstability purposes; international capitalmobility, which may be desired for accessto foreign capital; and autonomous mon-etary policy, which may be desired formanaging the business cycle or providinga lender of last resort. The logic is thatunder a fixed exchange rate and capitalmobility, simple interest parity means thatthe local interest rate must equal the“world” interest rate, and monetary poli-cy is rendered ineffective (or impossible).Something has to give if monetary policyis to be enabled: either the exchange ratemust float or capital controls must beapplied to suspend parity and admit inter-est differentials.

Prevailing narratives that tell the his-tory of the world in four parts (that is, themacroeconomic history since 1870) buildon the trilemma’s logic.3 In the classicalgold standard (1870–1914) monetary

policy was subordinated to the goals ofcapital mobility and a fixed exchange rate.In the interwar period, perhaps becauseof increasing democratic pressure, gov-ernments felt the need to useautonomous monetary policy; what gavewas the peg (the collapse of the goldstandard) or, in some cases, capital mobil-ity. But the economic chaos and instabili-ty of the interwar period was intolerableto those planning the contours of thepostwar global economy at BrettonWoods, and fixed exchange rates werestill viewed as a sine qua non for a stableworld economy. The new arrangementswould sacrifice capital mobility to keepcurrencies on “adjustable” pegs to thedollar and yet preserve monetary policyautonomy. Still, this system could notendure: capital movements (often dis-guised) grew in the 1960s, the adjustabili-ty of pegs invited speculative attacks, andimporting rising inflation from the U.S.anchor currency imposed costs on theother players. From 1971 onwards, themajor economies have floated, adaptingto (even encouraging) capital mobility,and resolving the trilemma in the onlyother way that preserves policy autonomy.

The trilemma sounds like a nicestory, but what is its explanatory powerand historical relevance? This hithertounexplored question can be addressed beexamining the degree of correlationbetween “local” and “world” interestrates, controlling for the type ofexchange rate regime and capital controlregime in operation. Tested in this way,the trilemma finds strong support in allhistorical eras from the Gold Standard tothe present and under a wide variety ofmacroeconomic regimes. These findingsprovide an evidentiary base for ouraccounts of global macroeconomic his-tory; they also give much-needed empiri-cal weight to the idea of the trilemma,one of the most fundamental constraintsthat economic policymakers have all toooften ignored, to their peril.


The Rise and Fall of WorldTrade

The historical patterns of globaliza-tion seen in capital markets also carry overto goods markets and the history of inter-national trade. Circa 1870, the ratio ofworld trade to GDP stood at 10 percent,rising to 21 percent by 1914, falling to 9percent by 1938, and then rising to 27percent by 1992: a first phase of global-ization followed by that twentieth-century“U-shape” again. What can explain thisrise and fall (and rise) of world trade?This has been another major goal in myresearch.4

To understand trade patterns in thelong run requires that we adopt a theoret-ical model and estimate its parametersusing long-run data. Two models standout as leading contenders for this job.First, the Heckscher-Ohlin model, inwhich trade happens as a result of differ-ences in countries’ factor endowments;second, the so-called gravity model, inwhich countries export differentiatedproducts in proportion to their owncountry size and subject to distance-relat-ed transport costs.5

Getting the Heckscher-Ohlin modelto match real world data has generatedendless problems with postwar data: rela-tive abundance (or scarcity) of a particu-lar factor is a poor predictor of whethersaid factor will tend to be exported(respectively, imported) by any givencountry. Instead, the so-called factor con-tent of trade goes the “wrong” way. And,even more perplexing, the volume oftrade is far too small to be consistent withthe model — the so-called paradox of“missing trade,” which can only be solved(or assumed away) theoretically withstrong anti-trade axioms of home bias. Itthus might be expected that with datafrom distant history, from the period1870-1939, we might also encounterproblems with the theory. This is broadlytrue, although we can find some weaksupport for the model as it applies to nat-

ural resources — arguably the factors thatwere uppermost in Heckscher andOhlin’s minds.6

Turning to the gravity model, howev-er, results in something more like anempirical success with historical data, as Ihave found in research with various col-laborators. Again, this matches the empir-ical success of the gravity model usingpostwar data. Yet if our goal is to under-stand why trade rose and fell so markedlyover time, an unadorned gravity model isnot much help, since relative country sizesand distances change little over time.Instead we need to include other meas-ures of policies, institutions, and thechanging economic environment, andsome obvious candidates stand out herefor the late nineteenth and early-to-midtwentieth century: the rise and fall of thegold standard, a monetary arrangementwhich was believed to be a stimulus ofworld trade; the transportation revolution,which dramatically lowered long-distanceshipping costs before 1914 through tech-nological change in shipping and the con-struction of major canals; changes in tar-iff policy, particularly after 1914 whentrade policy activism became common;and the impact of wars, particularly thetwo World Wars which affected a largefraction of the world economy.

The results of these studies give littlehope that a monocausal explanation willsuffice to explain the history of worldtrade. We find that the gold standardmade a difference, and when two coun-tries both go onto the gold standard theirbilateral trade rises by 42 percent, whichhelps to account for much of the rise intrade before 1914, and much of its disap-pearance by 1939. There are direct paral-lels here, of course, with the contempo-rary debate over the impact of commoncurrencies on trade, especially the long-run impacts of the euro. We also find thatthe decline of transport costs likewisemade a big difference in the 1870–1914period, explaining a large fraction of thetrade boom; but after 1914, trade costs

rose (relative to wholesale prices) helpingto turn the boom into a bust. Interwar tar-iff policy, especially in the 1930s, was alsoan important culprit in the collapse ofworld trade.

Finally, war matters. In very recentwork, we have found that wars have aprofound — and very persistent —effecton trade between countries.7 In wartimeperhaps 90 percent or more of tradebetween countries simply disappears; buteven after the war ends, we find that ittakes about ten years for trade to return tonormal “peacetime” levels. This alsohelps to explain the precipitous drop ininterwar trade and the slow post-1945recovery: globally about 10 to 20 percentof world trade was probably destroyed bythe “war effect” alone. We also find large“negative externalities” from war, in thesense that even neutral countries suffer adrop in trade when their trading partnersenter a conflict. A speculative and roughestimate of the costs of such “lost trade”finds that they might be significant in wel-fare terms, of the same order of magni-tude as the costs of lost human capital(measured by lost wages attributable todeaths or injuries). We have thereforebeen able to document a quantitativelyimportant cost of war that is subject tolarge spillovers, and that has been littleunderstood until now.

Future ResearchHistorical research on the past evolu-

tion of the global economy sheds newlight on the causes and consequences ofeconomic integration and the problemsand challenges it may cause for people,firms, and policymakers today and tomor-row. In recent years we have arrived atnew insights using the systematic, quanti-tative, cross-country and cross-timeapproach of the New ComparativeEconomic History, but there remainmany unanswered questions.

Understanding the frictions in theglobal economy is a central task forstudents of international trade and


finance in the past and present.8Methodologically, we shall continue todevelop better techniques to assess howglobalization has evolved, and how wellintegrated markets are at any given time.9We can then better understand how closewe are to a hypothetical single market ingoods and capital or how severe is “mar-ket failure.” These assessments also needto take into account the wide ranges ofpolicies and institutions that have operat-ed across time and space and which haveencouraged or inhibited internationaltrade and finance.

The latest research casts doubt onsimple generalizations that globalization isalways beneficial or always harmful;rather, its benefits appear to be greater incountries that climb up the ladder ofinstitutional quality. In time we will devel-op a more detailed knowledge of howglobalization has worked in different con-texts. We will then be better placed toknow whether the promises of prosperityheld out by the process of globalizationwill be shared by only a few, or — as KofiAnnan and many others hope — bymany.

1 This research was recently published in bookform: M. Obstfeld and A.M. Taylor, GlobalCapital Markets: Integration, Crisis, andGrowth, Japan-U.S. Center SanwaMonographs on International Financial Markets(Cambridge: Cambridge University Press,2004). We gratefully acknowledge the financialsupport of the Sanwa Prize in InternationalEconomics and Financial Markets. The relatedbackground papers, all of which appeared asNBER Working Papers, were published as fol-lows: M. Obstfeld, J.C. Shambaugh, and A.M.Taylor, “The Trilemma in History: Tradeoffsamong Exchange Rates, Monetary Policies, andCapital Mobility,” NBER Working Paper No.10396, March 2004, and Review ofEconomics and Statistics 87 (August2005), pp.423–38; “Monetary Sovereignty,Exchange Rates, and Capital Controls: TheTrilemma in the Interwar Period,” NBERWorking Paper No. 10393, March 2004, andIMF Staff Papers 51 (Special Issue 2004):

pp.75–108; M. Obstfeld and A.M. Taylor,“Sovereign Risk, Credibility, and the GoldStandard: 1870–1913 versus 1925–31,”NBER Working Paper No. 9345, November2002, and Economic Journal 113 (April2003), pp.1–35; “Globalization and CapitalMarkets,” NBER Working Paper No. 8846,March 2002, in Globalization in HistoricalPerspective, M. D. Bordo, A. M. Taylor, andJ. G. Williamson, eds. (Chicago: University ofChicago Press, 2003); A.M.Taylor, “A Centuryof Current Account Dynamics,” NBERWorking Paper No. 8927, May 2002, andJournal of International Money andFinance 21 (November 2002), pp. 725–48;A.M. Taylor, “A Century of Purchasing PowerParity,” NBER Working Paper No. 8012,November 2000, and Review of Economicsand Statistics 84 (February 2002),pp.139–50; M. Obstfeld and A.M. Taylor,“The Great Depression as a Watershed:International Capital Mobility in the LongRun,” NBER Working Paper No. 5960, May1999, in The Defining Moment: TheGreat Depression and the AmericanEconomy in the Twentieth Century, M. D.Bordo, C. D. Goldin, and E. N. White, eds.(Chicago: University of Chicago Press, 1998)2 See M.S. Feldstein and C.Y .Horioka,“Domestic Saving and International CapitalFlows,” Economic Journal 90 (1980), pp.314–29.3 For an influential example, see B.J. Eichengreen,Globalizing Capital: A History of theInternational Monetary System (Princeton,N.J.: Princeton University Press, 1996).4 The relevant published papers are as follows, andall appeared first as NBER Working Papers:A. Estevadeordal, B. Frantz, and A.M. Taylor,“The Rise and Fall of World Trade,1870–1939,” NBER Working Paper No.9318, November 2002, and QuarterlyJournal of Economics 118 (May 2003), pp.359–407; A.Estevadeordal and A.M.Taylor,“Testing Trade Theory in Ohlin’s Time,”NBER Working Paper No. 8842, March2002, in Bertil Ohlin: A CentennialCelebration, 1899–1999, R. Findlay, LJonung, and M. Lundahl, eds. (Cambridge:MIT Press, 2002); A. Estevadeordal andA.M. Taylor, “A Century of Missing Trade?”NBER Working Paper No. 8301, May 2001,and American Economic Review 92(March 2002), pp.383–93.5 For a thorough survey of these models see R.C.

Feenstra, Advanced International Trade:Theory and Evidence (Princeton, N.J.:Princeton University Press, 2004).6 The application of the Heckscher-Ohlin modelto the late nineteenth century works rather betterwhen its price predictions, rather than quantitypredictions, are put to the test. See K.H.O’Rourke, A.M. Taylor, and J.G. Williamson,“Factor Price Convergence in the Late NineteenthCentury,” NBER Historical Working PaperNo. 46, November 1996, and InternationalEconomic Review 37(1996), pp. 499–530;and K.H. O’Rourke and J.G. Williamson,Globalization and History: The Evolutionof a Nineteenth-Century Atlantic Econo-my (Cambridge: MIT Press, 1999).7 R.Glick and A.M.Taylor, “CollateralDamage: Trade Disruption and the EconomicImpact of War,” NBER Working Paper No.11565, August 2005.8 See, for example, M. Obstfeld and K. Rogoff,“The Six Major Puzzles in InternationalFinance: Is There a Common Cause?” NBERMacroeconomics Annual (2000), pp.339–90; and J.E. Anderson and E. vanWincoop, “Trade Costs,” Journal ofEconomic Literature, 42 (2004), pp. 691-751.9 In this area, one of the most promising avenuesappears to be the use of nonlinear models of priceadjustment to infer transaction costs. See E.Canjels, G. Prakash-Canjels, and A.M. Taylor,“Measuring Market Integration: ForeignExchange Arbitrage and The Gold Standard,1880–1913,” NBER Working Paper No.10583, June 2004, and Review ofEconomics and Statistics 86 (November2004), pp. 868–82; M.P. Taylor and A.M.Taylor, “The Purchasing Power Parity Debate,”NBER Working Paper No. 10607, July 2004,and Journal of Economic Perspectives 8(Fall 2004), pp. 135–58; A.M. Taylor,“Potential Pitfalls for the Purchasing-PowerParity Puzzle? Sampling and Specification Biasesin Mean-Reversion Tests of the Law of OnePrice,” NBER Working Paper No. 7577,March 2000, and Econometrica 69 (March2001), pp. 473–98; M.Obstfeld and A.M.Taylor, “Nonlinear Aspects of Goods-MarketArbitrage and Adjustment: Heckscher’sCommodity Points Revisited,” NBER WorkingPaper No. 6053, June 1997, and Journal ofthe Japanese and InternationalEconomies 11 (December 1997), pp.441–79.


NBER Profile: Bruce A. Blonigen

Bruce A. Blonigen is a ResearchAssociate in the NBER’s Program onInternational Trade and Investment andthe Knight Professor of Social Sciencein the economics department at theUniversity of Oregon. He received hisPh.D. in economics from the Universityof California, Davis in 1995. While com-pleting his dissertation, he also worked asan economist for the Research Divisionof the Office of Economics at the U.S.International Trade Commission.

Blonigen teaches courses in interna-tional economics, industrial organiza-tion, and statistical methods at both thegraduate and undergraduate level. Hewon the University of Oregon’s ErstedAward for Distinguished Teaching in2003.

Blonigen has published numerousarticles on foreign direct investment, aswell as on the economics of trade poli-cy, particularly antidumping trade pro-tection. He maintains a website thatshares information and data on U.S.antidumping activity. He also serves onthe editorial boards of the Journal ofInternational Economics, Canadian Journal ofEconomics, and the North American Journalof Economics and Finance, and is aDepartmental Editor for the Journal ofInternational Business Studies.

Blonigen lives in Eugene, Oregonwith his wife Denice Gray and their son,Ben. In his spare time, Blonigen is anavid golfer, and enjoys hikes and vaca-tions with the family.

NBER Profile: James Adams

James Adams is a ResearchAssociate in the Productivity Program ofthe National Bureau of EconomicResearch and a professor of economicsat Rensselaer Polytechnic Institute. Hereceived his Ph.D. degree from theUniversity of Chicago. Before moving toRensselaer he taught at the University ofFlorida and Iowa State University. He hasalso held visiting positions at the U.S.Bureau of Labor Statistics, the Bureau ofthe Census, and the George J. StiglerCenter for the Study of the Economyand the State at the University ofChicago.

Adams recently served on a NationalResearch Council panel on telecommuni-cations R and D. He also has advised theBureau of the Census and the AdvancedTechnology Program of the NationalInstitute of Standards and Technologyon the measurement of R and D.

In recent years, Adams’s researchinterests have centered on the connec-tions between industrial productivity inthe output of goods and inventions,industrial R and D, and pre-technologyscience, especially university research.His interests also extend to the boundarybetween technological change and laborand public economics.

He is married to Jennifer CobbAdams, has three cats, and lives in thescenic hill country near Rensselaer, NewYork. He enjoys music, especially classi-cal music from the seventeenth and eigh-teenth centuries; reading of a wide-rang-ing character; and nature studies. Whentime and the weather permit, he likes tokayak and canoe the lakes of northernNew York and Vermont. He also findsthat bicycling, hiking, and putteringaround the house form useful breaksfrom research and teaching.


NBER Profile: William J. Collins

William J. Collins is a ResearchAssociate in the NBER’s Developmentof the American Economy Program andan Associate Professor of Economics atVanderbilt University. Both his A.B.(1993) and his Ph.D. (1998) degrees ineconomics are from Harvard University.

Collins joined the Vanderbilt facultyin 1998. In the same year, he received theEconomic History Association’s AllanNevins Prize for the best dissertation ona North American topic.

During the 2001-2 academic year,Collins was a National Fellow at theNBER; in the 2003–4 academic year, he

was the Model-Okun Fellow at theBrookings Institution. Collins serves onthe editorial boards of Social ScienceHistory, Historical Methods, and the Journalof Economic History. He also manages thebook reviews on North American topicsfor the Journal of Economic History.

Collins grew up near Reading,Pennsylvania, and now lives in Nashville,Tennessee. In his spare time, he readsfiction and poetry, catches up on oldmovies, enjoys music around Nashville,and visits friends and family in Bostonand elsewhere.

NBER Profile: Alan M. Taylor

Alan M. Taylor is a ResearchAssociate in the NBER’s Programs onthe Development of the AmericanEconomy, International Finance andMacroeconomics, and InternationalTrade and Investment. He is also aProfessor of Economics and aChancellor’s Fellow at the University ofCalifornia, Davis, and the Director ofthe Center for the Evolution of theGlobal Economy. He received his Ph.D.from Harvard University.

For his dissertation, Taylor wasawarded the Alexander GerschenkronPrize by the Economic HistoryAssociation. For their work on globalcapital markets, he and Maurice Obstfeldwere awarded the 1997 Sanwa Prize inInternational Economics and Financial

Markets. Taylor has served as a consult-ant or visitor with the World Bank, theInternational Monetary Fund, the Inter-American Development Bank, and theFederal Reserve Bank of San Francisco.He currently holds a John SimonGuggenheim Memorial Fellowship andhas spent most of the last year on sab-batical in Paris and London.

When not on leave, Taylor lives inDavis, California, with his wife (who is aprofessor of literature), daughter, andcat. When he can find the time, Taylorenjoys listening to jazz and traveling toeither very urban or very remote places.He occasionally descends snow slopesand stands in rivers, but any resem-blances to skiing and fly-fishing are pure-ly coincidental.


Fannie Mae and Freddie Mac assumea significant amount of interest and pre-payment risk and all of the credit risk forabout half of the eight trillion dollar U.S.residential mortgage market. Theirhybrid government-private status, andthe perception that they are too big tofail, make them a potentially large, butmainly unaccounted for, risk to the fed-eral government. Measuring the sizeand risk of this liability is technicallydifficult, but important for the debateover the appropriate regulation of theseinstitutions. Lucas and McDonald

take an options pricing approach toevaluating these costs and risks. Underthe base case assumptions, the estimat-ed value of the guarantees is $7.9 billionover ten years, with a combined 0.5 per-cent value at risk of $122 billion. Theauthors evaluate the sensitivity of theseestimates to various modeling assump-tions, and also to the regulatory regime,including forbearance policies and capi-tal requirements. Their analysis high-lights the benefits, but also the chal-lenges, of taking on options-basedapproach to evaluating the value of fed-

eral credit guarantees.When studying changes in the risks

of large bank holding companies(BHCs) and government-sponsoredenterprises (GSEs), researchers routine-ly argue that changes in the responsive-ness of stock and subordinated bondreturns to exogenous risk factors can beinterpreted as reflecting changes ininvestors’ views about the firm’s expect-ed losses. However, investors may per-ceive that these large firms have sub-stantial implicit government guarantees.Hancock and Passmore show that

Conferences

An NBER Conference on theRisks of Financial Institutions washeld in Cambridge on November 10.Mark Carey, Federal Reserve Board,and Rene M. Stulz, NBER and OhioState University, organized the meet-ing, at which the following paperswere discussed:

Deborah Lucas, NorthwesternUniversity and NBER, and RobertMcDonald, Northwestern University,“An Options-Based Approach toEvaluating the Risk of Fannie Mae andFreddie Mac”

Diana Hancock and WaynePassmore, Federal Reserve Board,“Understanding Market Discipline inthe Presence of Implicit GovernmentGuarantees: An Analysis of Subordi-nated Bond and Stock Returns forGSEs and for Bank Holding Com-panies”Discussant for both papers: ThomasWilson, ING

Markus Brunnermeier, PrincetonUniversity, and Lasse Heje Pedersen,New York University, “MarketLiquidity and Funding Liquidity”Discussant: Jeremy C. Stein, HarvardUniversity and NBER

Gregory W. Brown, University ofNorth Carolina, Chapel Hill; SöhnkeM. Bartram, Lancaster University; andJohn E. Hund, University of Texas atAustin, “Estimating Systemic Risk inthe International Financial System”Discussant: Anthony Saunders, NewYork University

Viral Acharya and Timothy Johnson,London Business School, “InsiderTrading in Credit Derivatives”Discussant: Louis Scott, MorganStanley

Torben G. Andersen, NorthwesternUniversity and NBER; TimBollerslev, Duke University andNBER; and Francis X. Diebold,

University of Pennsylvania and NBER,“Roughing It Up: Including JumpComponents in the Measurement,Modeling, and Forecasting of ReturnVolatility”(NBER Working Paper No.11775)Discussant: Eric Ghysels, Universityof North Carolina, Chapel Hill

Samuel Hanson, Harvard University;M. Hashem Pesaran, University ofCambridge; and Til Schuermann,Federal Reserve Bank of New York,“Firm Heterogeneity and Credit RiskDiversification”Discussant: David M. Lando, Copen-hagen Business School

Sanjiv Das, Santa Clara University;Darrell Duffie, Stanford Universityand NBER; Nikunj Kapadia,University of Massachusetts; andLeandro Saita, Stanford University,“Common Failings: How CorporateDefaults Are Correlated”Discussant: David Li, Barclays Capital

Risks of Financial Institutions


these guarantees can confound theinterpretation of stock and bond returnresponsiveness, making changes in theresponsiveness of bond returns difficultto interpret. They also show thatchanges in the responsiveness of stockreturns are almost impossible to inter-pret. These results suggest that implicitguarantees can hide investors’ percep-tions of changes in expected loss attrib-utable to important risk factors, therebyconfounding market and regulatoryefforts to correctly price and managerisks. The authors provide conditionsunder which bond returns can be use-fully interpreted as reflecting expectedlosses and thus the relative riskiness offirms. They consider the risk-sensitivityof subordinated bond returns of highlyrated BHCs and of GSEs to macroeco-nomic shocks during two periods: April1, 2001 to May 31, 2003 and June 1,2003 to September 15, 2004. Althoughthe GSEs (Fannie Mae and FreddieMac) and the largest U.S. bank holdingcompanies may benefit substantiallyfrom a perceived implicit governmentguarantee of their liabilities, the politicalsupport for government backing of theGSEs seemed less certain to investorsin the later period, while there was nonews, or legislative developments, thatlikely would have changed the perceivedimplicit government guarantees forBHCs. The authors show that theresponsiveness of subordinated bondreturns to macroeconomic shocks dur-ing the two sample periods indicatethat: 1) BHCs’ bond returns across thetwo periods became less sensitive tochanges in macroeconomic factors thataffect credit risks but more sensitive tochanges in macroeconomic factors thatinfluence interest rate risks; 2) changesin implicit guarantees made it difficultto interpret GSE bond returns acrossthe two periods; and 3) bond investorsgenerally believed that GSEs are at leastas risky, and maybe more risky, (that is,their expected losses are more sensitive

to macroeconomic risk factors) whencompared with BHCs. While their tech-nique does not identify the source ofthis potentially greater risk, the authorsnote that financial theory would suggestthat GSEs might have greater risksbecause they are less diversified and notas well capitalized as BHCs.

Brunnermeier and Pedersen pro-vide a model that links a security’s mar-ket liquidity — that is, the ease of trad-ing it — to traders’ funding liquidity —that is, their availability of funds.Traders provide market liquidity andtheir ability to do so depends on theirfunding — that is, their capital and themargins charged by their financiers. Intimes of crisis, reductions in market liq-uidity and funding liquidity are mutuallyreinforcing, leading to a liquidity spiral.The model here explains the empirical-ly documented features that market liq-uidity: 1) can suddenly dry up (in otherwords, is fragile); 2) has commonalityacross securities; 3) is related to volatili-ty; 4) experiences “flight to liquidity”events; and 5) co-moves with the mar-ket. Finally, the model shows how theFed can improve current market liquid-ity by committing to improving fundingin a potential future crisis.

With a unique and comprehensivedataset, Bartram, Brown, and Hunddevelop and use three distinct methodsto quantify the risk of a systemic failurein the global banking system. Theyexamine a sample of 334 banks (repre-senting 80 percent of global bank equi-ty) in 28 countries around six globalfinancial crises (such as the Asian andRussian crises and September 11, 2001),and show that these crises did not cre-ate large probabilities of global financialsystem failure. First, they show thatcumulative negative abnormal returnsfor the subset of banks not directlyexposed to a negative shock (unexposedbanks) rarely exceed a few percent.Second, they use structural models toobtain more precise point estimates of

the likelihood of systemic failure. Theseestimates suggest that systemic risk islimited, even during major financialcrises. For example, maximum likeli-hood estimation of bank failure proba-bilities implied by equity prices suggeststhe Asian crisis induced less than a sin-gle percent increase in the probability ofsystemic failure. Third, the authors esti-mate systemic risk as implied by equityoption prices of U.S. and Europeanbanks. The largest values are for theRussian crisis and September 11; theseshow increases in estimated averagedefault probabilities of only around 1-2percent. Taken together, the results sug-gest statistically significant, but eco-nomically small, increases in systemicrisk around even the worst financialcrises of the last ten years. Althoughpolicy responses are endogenous, thelow estimated probabilities suggest thatthe distress of central bankers, regula-tors and politicians about the eventsthey study may be overstated, and thatcurrent policy responses to financialcrises and the existing institutionalframework may be adequate to handlemajor macroeconomic events.

Insider trading in the credit deriva-tives market has become a significantconcern for regulators and participants.Acharya and Johnson attempt toquantify the problem. Using newsreflected in the stock market as a bench-mark for public information, theyreport evidence of significant incre-mental information revelation in thecredit default swap (CDS) market undercircumstances consistent with the useof non-public information by informedbanks. Specifically, the information rev-elation occurs only for negative creditnews and for entities that subsequentlyexperience adverse shocks. Moreover,the degree of advance information rev-elation increases with the number ofbanks that have lending/monitoringrelations with a given firm, and thiseffect is robust to controls for non-


informational trade. They find no evi-dence, however, that the degree ofasymmetric information adverselyaffects prices or liquidity in either theequity or credit markets. If anything,with regard to liquidity, the reverseappears to be true.

A rapidly growing literature hasdocumented important improvementsin financial return volatility measure-ment and forecasting through the use ofrealized variation measures constructedfrom high-frequency returns, coupledwith simple modeling procedures.Building on recent theoretical results inBarndorff-Nielsen and Shephard(2004a, 2005) for related bi-power vari-ation measures, Andersen, Bollerslev,and Diebold provide a practical androbust framework for non-parametri-cally measuring the jump component inasset return volatility. In an applicationto the DM/$ exchange rate, theS&P500 market index, and the 30-yearU.S. Treasury bond yield, they find thatjumps are both highly prevalent and dis-tinctly less persistent than the continu-ous sample path variation process.Moreover, many jumps appear directlyassociated with specific macroeconom-ic news announcements. Separatingjump from non-jump movements in asimple but sophisticated volatility fore-

casting model, the authors find thatalmost all of the predictability in daily,weekly, and monthly return volatilitiescomes from the non-jump component.Their results thus set the stage for anumber of interesting future economet-ric developments and important finan-cial applications by separately modeling,forecasting, and pricing the continuousand jump components of the totalreturn variation process.

Hanson, Pesaran, and Schuer-mann consider a simple model of cred-it risk and derive the limit distributionof losses under different assumptionsregarding the structure of systematicand idiosyncratic risks and the nature offirm heterogeneity. Their theoreticalresults indicate that if firm-specific riskexposures (including their defaultthresholds) are heterogeneous butcome from a common parameter distri-bution, then there is no scope for fur-ther risk reduction through active cred-it portfolio management for sufficientlylarge portfolios. However, if the firmrisk exposures are drawn from differentparameter distributions, say for differ-ent sectors or countries, then furtherrisk reduction is possible, even asymp-totically, by changing the portfolioweights. In either case, neglectingparameter heterogeneity can lead to

underestimation of expected losses.But, once expected losses are controlledfor, neglecting parameter heterogeneitycan lead to overestimation of risk,whether measured by unexpected lossor value-at-risk. These results are con-firmed empirically using returns andcredit ratings for firms in the UnitedStates and Japan across seven sectors.Ignoring parameter heterogeneityresults in far riskier credit portfolios.

Das, Duffie, Kapadia, and Saitadevelop, and apply to data on U.S. cor-porations from 1979-2004, tests of thestandard doubly-stochastic assumptionunder which firms’ default times arecorrelated only as implied by the corre-lation of factors determining theirdefault intensities. This assumption isviolated in the presence of contagion or“frailty” (unobservable explanatoryvariables that are correlated acrossfirms). The tests here do not depend onthe time-series properties of defaultintensities. The data do not support thejoint hypothesis of well-specifieddefault intensities and the doubly-sto-chastic assumption. There is also someevidence of default clustering in excessof that implied by the doubly-stochasticmodel with the given intensities.

*


Aizenman and Noy study theendogenous determination of financialand trade openness when both arevolatile. First, they outline channelsleading to two-way feedback betweenthe different modes of openness; next,they identify these feedbacks empirical-ly. They find that a single standard devi-ation increase in commercial opennessis associated with a 9.5 percent (ofGDP) increase in de-facto financialopenness, controlling for political econ-omy and macroeconomic factors.Similarly, an increase in de-facto finan-

cial openness has powerful effects onfuture trade openness. While de-jurerestrictions on capital mobility do notaffect de-facto financial openness, de-jure restrictions on the current accounthave large adverse effect on commercialopenness. This suggests that it is mucheasier to overcome restrictions on capi-tal account convertibility than restric-tions on commercial trade. Havingestablished (Granger) causality, theauthors investigate the relative magni-tudes of these directions of causalityusing Geweke’s (1982) decomposition

methodology. They find that almost allof the linear feedback between tradeand financial openness can be account-ed for by G-causality from financialopenness to trade openness (53 per-cent) and from trade to financial open-ness (34 percent). They conclude that,in an era of rapidly growing trade inte-gration, countries cannot choose finan-cial openness independent of theirdegree of openness to trade —dealingwith greater exposure to financial tur-bulence by curbing financial flows willlikely be ineffectual.

The NBER and PontificiaUniversidade Catolica do Rio deJaneiro (PUC-Rio) jointly sponsored ameeting of the Inter-American Semi-nar on Economics in Brazil onDecember 2 and 3. This Seminarfocused on “Strengthening GlobalFinancial Markets.” NBER ResearchAssociate Sebastian Edwards ofUniversity of California, Los Angeles,and Marco Garcia of PUC-Rio, organ-ized the following program:

Joshua Aizenman, University ofCalifornia at Santa Cruz and NBER,and Ilan Noy, University of Hawaii,“Endogenous Financial and TradeOpenness in a Volatile World”Comments: Maria Cristina Terra,Postgraduate School of Economics -Brazil (EPGE), and Thierry Verdier,Centre for Economic Policy Research

Bernardo S. de M. Carvalho, GáveaInvestments, and Marcio Garcia,“Ineffective Controls on CapitalInflows under Sophisticated FinancialMarkets: Brazil in the Nineties”Comments: Gustavo Franco andMarcelo Abreu, PUC-Rio

Sebastian Edwards, “FinancialOpenness, Crises, and Output Losses”Comments: Edmar Bacha, Bank ofItaly, and Marcelo Muinhos, BancoCentral do Brasil

Viviana Fernandez, Universidad deChile, “The International CAPM and aWavelet-based Decomposition ofValue at Risk”Comments: Marcelo Medeiros, PUC-Rio, and Caio Ibsen, IBMEC BusinessSchool-Rio

Ross Levine, NBER and BrownUniversity, and Sergio L. Schmukler,The World Bank, “Internationalizationand Stock Market Liquidity”Comments: Ugo Panizza, Inter-American Development Bank, andEduardo Loyo, IMF

Ricardo J. Caballero, NBER andMIT; Takeo Hoshi, NBER andUniversity of California at San Diego;and Anil K Kashyap, University ofChicago and NBER, “Zombie Lendingand Depressed Restructuring in Japan”Comments: Vinicius Carrasco andWalter Novaes, PUC-Rio

Ana Carla A Costa, Banco Central doBrasil, and Joao Manoel Pinho deMello, PUC-Rio, “Judicial Risk andCreditor Expropriation: MicroEvidence from Brazilian PayrollLoans”Comments: Renato Flores, EPGE/FGV,and Beny Parnes, PUC-Rio

Eduardo Levy-Yeyati, UniversidadTorcuato di Tella, “Liquidity Insurancein Financially Dollarized Economy”Comments: Marco Bonomo, EPGE,and Alejandro Werner, Subsecretaria deHacienda y Credito Publico do Mexico

Barry J. Eichengreen, University ofCalifornia at Berkeley and NBER; andPoonam Gupta and Ashoka Mody,IMF, “Sudden Stops and IMFPrograms”Comments: Ilan Goldfajn, PUC-Rio,and Affonso Celso Pastore, ACPastore& Associados

IASE: Strengthening Global Financial Markets


Carvalho and Garcia analyze theBrazilian experience in the 1990s toassess the effectiveness of controls oncapital inflows in restricting financialinflows and changing their compositiontowards long-term flows. Econometricexercises (VARs) lead them to concludethat controls on capital inflows wereeffective in deterring financial inflowsfor only a brief period, from two to sixmonths. The hypothesis to explain theineffectiveness of the controls is thatfinancial institutions performed severaloperations aimed at avoiding capitalcontrols. The authors conducted inter-views with market players in order toprovide several examples of the finan-cial strategies that were used in this peri-od to invest in the Brazilian fixedincome market while bypassing capitalcontrols. Their main conclusion is thatcontrols on capital inflows, while theymay be desirable, are of very limitedeffectiveness under sophisticated finan-cial markets. Therefore, policymakersshould avoid spending the scarceresources of bank supervision trying toimplement them and focus more inimproving economic policy.

Edwards uses a broad multi-coun-try dataset to analyze the relationshipbetween restrictions to capital mobilityand external crises. The analysis focuseson two manifestations of external crises:sudden stops of capital inflows; and cur-rent account reversals. He deals with twoimportant policy-related issues: first,does the extent of capital mobility affectcountries’ degree of vulnerability toexternal crises; and second, does theextent of capital mobility determine thedepth of external crises — as measuredby the decline in growth — once thecrises occur? Overall, his results castsome doubts on the assertion thatincreased capital mobility has causedheightened macroeconomic vulnerabili-ties. He finds no systematic evidencesuggesting that countries with highercapital mobility tend to have a higher

incidence of crises, or to face a higherprobability of having a crisis, than coun-tries with lower mobility. His results dosuggest, however, that once a crisisoccurs, countries with higher capitalmobility may face a higher cost, in termsof growth decline.

Fernandez formulates a time-scaledecomposition of an international ver-sion of the Capital Asset Pricing Modelthat accounts for both market andexchange-rate risk. In addition, shederives an analytical formula for time-scale value at risk and marginal value atrisk (VaR) of a portfolio. She appliesthe methodology to stock indexes ofseven emerging economies in LatinAmerica and Asia, for the sample peri-od 1990-2004. Her main conclusionsare: 1) the estimation results hinge uponthe choice of the world market portfo-lio. In particular, the stock markets ofthe sampled countries appear to bemore integrated with other emergingcountries than with developed ones. 2)Value at risk depends on the investor’stime horizon. In the short run, potentiallosses are greater than in the long run.3) Additional exposure to some specificstock indices will increase value at riskto a greater extent, depending on theinvestment horizon. These results are inline with recent research in asset pricingthat stresses the importance of hetero-geneous investors.

What is the impact of internation-alization (firms raising capital and trad-ing in international markets) on the liq-uidity of the remaining firms in domes-tic markets? To address this question,Levine and Schmukler assemble apanel database of more than 2,700firms from 45 emerging economiesover the period 1989-2000, constructedfrom annual and daily data. First, theyfind evidence of migration. There is areduction in the domestic trading offirms that cross-list or issue depositaryreceipts in foreign public exchanges astrading migrates from domestic to

international markets. Second, there areliquidity spillovers within markets.Aggregate domestic trading activity isassociated with the liquidity of individ-ual firms in the same market. The evi-dence is consistent with the view thatwhen firms cross-list or issue depositaryreceipts in public international markets,the domestic trading activity of theirshares falls, hurting the liquidity of theremaining firms in their home market.

Caballero, Hoshi, and Kashyapproposes a bank-based explanation forthe decade-long Japanese slowdown.The starting point for their story is thewell-known observation that most largeJapanese banks were only able to complywith capital standards because regulatorswere lax in their inspections. To facilitatethis forbearance, the banks oftenengaged in sham loan restructuring thatkept credit flowing to otherwise insol-vent borrowers (“zombies”). Thus, thenormal competitive outcome, wherebythe zombies would shed workers andlose market share, was thwarted. Theauthors’ model highlights the restructur-ing implications of the zombie problem.The counterpart of the congestion cre-ated by the zombies is a reduction inprofits for potential new and more pro-ductive entrants, which discourages theirentry. In this context, even solvent bankswill not find good lending opportunities.The authors confirm their story’s keypredictions — that zombie-dominatedindustries exhibit more depressed jobcreation and destruction, lower produc-tivity, and greater excess capacity. Mostimportantly, they present firm-levelregressions showing that the increase inzombies has depressed the investmentand employment growth of non-zom-bies and has been associated with awidening of the productivity gapbetween zombies and non-zombies. Theevidence suggests that the healthiestnon-zombies were harmed the most bythe zombies.

A large body of literature has


stressed the institution-developmentnexus as critical in explaining differ-ences in countries’ economic perform-ance. The empirical evidence, however,has been mainly on the aggregate level,associating macro performance withmeasures of quality of institutions. ACosta and De Mello, by relating a judi-cial decision on the legality of payrolldebit loans in Brazil to bank-level deci-sion variables, provide micro evidenceon how creditor legal protection affectsmarket performance. Payroll debit loansare personal loans with principal andinterests payments directly deductedfrom the borrowers’ payroll check,which, in practice, makes collateral outof future income. In June 2004, a high-level federal court upheld a regionalcourt ruling that had declared payrolldeduction illegal. Using personal loanswithout payroll deduction as a controlgroup, the authors assess whether theruling had an impact on market per-formance. The evidence indicates that ithad an adverse impact on banks’ riskperception, on interest rates, and on theamount lent.

Unlike the financial dollarization(FD) of external liabilities, the dollariza-tion of domestic financial assets(domestic FD) has received compara-tively less attention until very recently,when increasingly it has been seen as akey source of real exchange rate expo-sure and balance sheet problems. Levy-Yeyati focuses on an a complementary—and often overlooked— angle ofdomestic FD: the limit it imposes onthe central bank as domestic lender oflast resort (LLR), and the resultingexposure to (dollar) liquidity runs. Headdresses this issue in three steps. First,he illustrates the incidence of FD onthe propensity to suffer bank runs (andthe authorities’ belated reaction) bymeans of two recent banking crises,Argentina 2001 and Uruguay 2002, andshows that FD has been an importantmotive for self-liquidity insurance in theform of reserve accumulation. Next, heexplores the incentive problems associ-ated with centralized self-insurance(holdings of reserves at the centralbank). In this light, he argues for a com-bined scheme of decentralized liquid

asset requirement (LAR) and an ex-antesuspension-of-convertibility clause or“circuit breaker” (CBR), as a way toreduce self-insurance costs while limit-ing bank losses in the event of a run.

Eichengreen, Gupta, and Modypresent evidence on the impact of IMFprograms on sudden stops in capitalflows. Their results are consistent withthe notion that IMF programs havesome positive effect in reducing theincidence of these events. At the sametime, there is little evidence that largerFund programs more effectively inocu-late countries against sudden stops.Newly-negotiated programs seem to bemore effective in this regard than long-standing arrangements. It is tempting tointerpret both observations as indicat-ing that the signaling effect of IMF pro-grams matters more than the emer-gency financial assistance. Finally, theauthors are unable to identify evidencethat IMF programs are more effective atinsulating countries from sudden stopswhen they already have fundamentallystrong policies in place.

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Most of the reduction in GDPvolatility since 1983 is accounted for bya decline in the comovement of outputamong industries that hold inventories.This decline is not simply a passivebyproduct of reduced volatility in com-mon factors or shocks. Instead, struc-tural changes occurred in the long runand there were dynamic relationshipsamong industries’ sales and inventoryinvestment behavior — especially in theautomobile and related industries,which are linked by supply and distribu-tion chains that feature new production

and inventory management techniques.Using a HAVAR model (Fratantoni andSchuh 2003) with only two sectors —manufacturing and trade — Irvine andSchuh discover structural changes thatreduced the comovement of sales andinventory investment both within andbetween industries. As a result, theresponse of aggregate output to alltypes of shocks was dampened.Structural changes accounted for morethan 80 percent of the reduction in out-put volatility, thus weakening the casefor “good luck,” and altered industries’

responses to federal funds rate shocks,thus suggesting that the case for “bettermonetary policy” is complicated bychanges in the real side of the economy.

In much of the world, growth ismore stable than it once was. Lookingat a sample of 25 countries, Cecchetti,Flores-Lagunes, and Krause find thatin 16 of them, real GDP growth is lessvolatile today than it was 20 years ago.And, these declines are large, averagingmore than 50 percent. What accountsfor the fact that real growth has beenmore stable in recent years? The

On December 9 and 10, anNBER/Universities Research Confer-ence on “Structural Changes in theGlobal Economy: Implications forMonetary Policy and FinancialRegulation” took place in Cambridge.NBER Research Associates AndrewB. Abel, The Wharton School, andJanice C. Eberly, Northwestern Uni-versity’s Kellogg School of Manage-ment, organized this program:

F. Owen Irvine, Michigan StateUniversity, and Scott Schuh, FederalReserve Bank of Boston, “The Rolesof Comovement and InventoryInvestment in the Reduction of OutputVolatility”Discussant: William Dupor, Ohio StateUniversity

Stephen G. Cecchetti, BrandeisUniversity and NBER; AlfonsoFlores-Lagunes, University of Ari-zona; and Stefan Krause, EmoryUniversity, “Assessing the Sources ofChanges in the Volatility of RealGrowth”

Discussant: James H. Stock, HarvardUniversity and NBER

Sebnem Kalemli-ozcan, University ofHouston and NBER; Ariell Reshef,New York University; and Bent E.Sorensen, University of Houston,“Productivity and Capital Flows:Evidence from U.S. States”Discussant: John Coleman, DukeUniversity

Charles A. Trzcinka and Andrey D.Ukhov, Indiana University, “FinancialGlobalization and Risk Sharing:Welfare Effects and the Optimality ofOpen Markets”Discussant: Leonid Kogan, MIT andNBER

Giovanni Olivei, Federal ReserveBank of Boston, and SilvanaTenreyro, London School ofEconomics, “The Timing of MonetaryPolicy Shocks”Discussant: Marc Giannoni, ColumbiaUniversity and NBER

Hoyt Bleakley, University of Califor-nia, San Diego, and Kevin Cowan,Inter-American Development Bank,“Maturity Mismatch and FinancialCrises: Evidence from EmergingMarket Corporations”Discussant: Mark Aguiar, FederalReserve Bank of Boston

Prasanna Gai and Nicholas Vause,Bank of England, and Peter Kondor,London School of Economics,“Procyclicality, Collateral Values, andFinancial Stability”Discussant: Adriano Rampini, North-western University

Söhnke Bartram, LancasterUniversity; Gregory W. Brown,University of North Carolina at ChapelHill; and John Hund, University ofTexas at Austin, “Estimating SystemicRisk in the International FinancialSystem”Discussant: Craig Furfine, FederalReserve Bank of Chicago

Structural Changes in the Global Economy


authors survey the evidence and com-peting explanations and find supportfor the view that improved inventorymanagement policies, coupled withfinancial innovation, adopting an infla-tion targeting scheme, and increasedcentral bank independence have allbeen associated with more stable realgrowth. Furthermore, they find weakevidence suggesting that increasedcommercial openness has coincidedwith increased output volatility.

Kalemli-Ozcan, Reshef, andSorensen study the determinants ofnet capital income flows within theUnited States where capital freelymoves across state borders. They use asimple neoclassical model in which totalfactor productivity (TFP) varies acrossstates and over time and capital owner-ship is perfectly diversified across stateborders. Capital will flow to states thatexperience an increase in TFP resultingin net cross-state investment positions.Net ownership positions revert to zeroover time in the absence of further TFPmovements. States with increasing TFPpay net capital income to states withdeclining TFP relative to the U.S. aver-age. While TFP cannot be directlyobserved, the authors can identify stateswith high TFP growth as states withhigh output growth. By comparing thelevel of state personal income to stategross product, they construct indicatorsof net capital income flows. They thenexamine empirically whether net capitalincome flows between states corre-spond to the predictions of the modeland whether net capital positions tendto converge to zero. The empirical find-ings indicate persistent net capitalincome flows across states, which are anorder of magnitude larger than theequivalent counterparts across coun-tries. Thus, the results imply that fric-tions associated with borders are likelyto be the main explanation for lowinternational capital flows.

Trzcinka and Ukhov study the

welfare effects of investment barriersand the opening of markets to foreign-ers. They construct an equilibriummodel of international asset pricingwithout agency costs that allowsendogenous market participationamong heterogeneous agents.Equilibrium prices and the set of par-ticipating and non-participating agentsare jointly determined in equilibriumand the ability of agents to choose toparticipate in the market affects pricesof domestic and foreign assets. Theauthors examine the welfare effects ofnon-participation and find that when acountry moves from complete segmen-tation to open markets for foreigners,the cost of capital falls in the domesticmarket. This is consistent with empiri-cal findings in the international assetpricing literature. Through the endoge-nous participation mechanism, themodel is able to capture sources of eco-nomic growth. Contrary to previousmodels, however, this one shows thatopening markets is not Pareto-optimaland the authors identify a class ofdomestic agents whose welfare is lowerafter the opening of markets. Thesefinding have political economy interpre-tations and policy implications.

A vast empirical literature has doc-umented delayed and persistent effectsof monetary policy on output. Oliveiand Tenreyro show that this findingresults from the aggregation of outputimpulse responses that differ sharplydepending on the timing of the shock:When the monetary policy shock takesplace in the first two quarters of theyear, the response of output is quick,sizable, and dies out at a relatively fastpace. In contrast, output responds verylittle when the shock takes place in thethird or fourth quarter. The authorspropose a potential explanation for thedifferential responses based on unevenstaggering of wage contracts acrossquarters. Using a stylized dynamic gen-eral equilibrium model, they show that a

very modest amount of uneven stagger-ing can generate differences in outputresponses similar to those found in thedata.

Substantial attention has been paidin recent years to the risk of maturitymismatch in emerging markets.Although this risk is microeconomic innature, the evidence advanced thus farhas taken the form of macro correla-tions. Bleakley and Cowan evaluatethis mechanism empirically at the microlevel by using a database of over 3000publicly traded firms from fifteenemerging markets. They measure therisk of short-term exposure by estimat-ing, at the firm level, the effect oninvestment of the interaction of short-term exposure and aggregate capitalflows. This effect is (statistically) zero,contrary to the prediction of the matu-rity-mismatch hypothesis. This conclu-sion is robust to using a variety of dif-ferent estimators, alternative measuresof capital flows, and controls for deval-uation effects and access to internation-al capital. The authors do find evidencethat short-term-exposed firms payhigher financing costs and liquidateassets at resale prices, but not that thisreduction in net worth translates into adrop in investment.

Gai, Kondor, and Vause analyzehow the risk-sharing capacity of thefinancial system varies over the businesscycle, leading to pro-cyclical fragility.They show how financial imperfectionscontribute to under-insurance by entre-preneurs, generating a pecuniary exter-nality that leads to the build-up of sys-tematic risk during upturns. Increasedasset price uncertainty emerges as asymptom of the sectoral concentrationthat builds up during booms. The liq-uidity of the collateral asset is shown toplay a key role in amplifying the finan-cial cycle. The welfare costs of financialstability, in terms of the efficiency costsattributable to financial frictions and thevolatility costs attributable to amplifica-


tion, also are illustrated.With a unique and comprehensive

dataset, Bartram, Brown, and Hunddevelop and use three distinct methodsto quantify the risk of a systemic failurein the global banking system. Theyexamine a sample of 334 banks (repre-senting 80 percent of global bank equi-ty) in 28 countries around 6 globalfinancial crises (such as the Asian andRussian crises and September 11, 2001),and show that these crises did not cre-ate large probabilities of global financialsystem failure. First, they show thatcumulative negative abnormal returnsfor the subset of banks not directlyexposed to a negative shock (unexposed

banks) rarely exceed a few percent.Second, they use structural models toobtain more precise point estimates ofthe likelihood of systemic failure. Theseestimates suggest that systemic risk islimited even during major financialcrises. For example, maximum likeli-hood estimation of bank failure proba-bilities implied by equity prices suggeststhat the Asian crisis induced less than a1 percent increase in the probability ofsystemic failure. Third, they obtain esti-mates of systemic risk implied by equi-ty option prices of U.S. and Europeanbanks. The largest values are obtainedfor the Russian crisis and September 11and these show increases in estimated

average default probabilities of onlyaround 1-2 percent. Taken together, theresults suggest statistically significant,but economically small, increases in sys-temic risk around even the worst finan-cial crises of the last ten years. Althoughpolicy responses are endogenous, thelow estimated probabilities suggest thatthe distress of central bankers, regula-tors, and politicians about the eventsstudied here may be over-stated, andthat current policy responses to finan-cial crises and the existing institutionalframework may be adequate to handlemajor macroeconomic events.

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Ogawa and Shimizu investigatehow effectively a common currencybasket peg would stabilize the effectiveexchange rates of East Asian curren-cies. The authors use an AsianMonetary Unit (AMU), which is aweighted average of the ASEAN10 plus3 (Japan, China, and Korea) currencies,as the common currency basket; theycompare their results with others on the

stabilization effects of the common G3currency (the U.S. dollar, the Japaneseyen, and the euro) basket in the EastAsian countries (Williamson, 2005).They find that the AMU peg systemwould be more effective in reducingfluctuations of effective exchange ratesas more countries in East Asia appliedit. Further, the AMU peg system wouldmore effectively stabilize effective

exchange rates than a common G-3 cur-rency basket peg system for four(Indonesia, the Philippines, Singapore,and Thailand) of the seven countriesthey study. These results suggest thatthe AMU basket peg would be usefulfor the East Asian countries whoseintraregional trade weights are relativelyhigher than their trade weights withoutsiders.

The Eighteenth Annual TRIOConference, so-named because it isjointly sponsored by the NBER, theCentre for Economic Policy Research(CEPR), and the Tokyo Center forEconomic Research (TCER), tookplace on December 9 and 10 inTokyo. This year’s conference focusedon “International Finance.” It wasorganized by Shin-ichi Fukuda,University of Tokyo; Takeo Hoshi,NBER and University of California,San Diego; Takatoshi Ito, NBER andUniversity of Tokyo; and Andrew K.Rose, NBER and University ofCalifornia, Berkeley. The programwas:

Eiji Ogawa and Junko Shimizu,Hitotsubashi University, “Stabilizationof Effective Exchange Rates under aCommon Currency Basket System”Discussants: Taizo Motonishi, KansaiUniversity, and Mark Spiegel, FederalReserve Bank of San Francisco

Etsuro Shioji, Yokohama NationalUniversity, “Invoicing Currency andthe Optimal Basket Peg for East Asia:A New Open Economy Macroeco-nomics Perspective”Discussants: Kentaro Iwatsubo,Hitosubashi University, and Eiji Ogawa

Shang-jin Wei, IMF and NBER,“Connecting Two Views on FinancialGlobalization: Can We Make FurtherProgress?”Discussants: Yuko Hashimoto, ToyoUniversity, and Elias Papaioannou,European Central Bank

Takatoshi Ito, and Yuko Hashimoto,“Intra-Day Seasonality in Activities ofthe Foreign Exchange Markets:Evidence from the Electronic BrokingSystem”Discussants: Robert F. Engle, Univer-sity of California, San Diego andNBER, and Paolo Pesenti, FederalReserve Bank of New York

Shin-ichi Fukuda, and MasanoriOno, Fukushima University, “On theDeterminants of Export Prices:History vs. Expectations”Discussants: Andrew K. Rose, andKiyotaka Sato, Yokohama NationalUniversity

Allan Drazen, University of Marylandand NBER, and Stefan Hubrich, T.Rowe Price, “A Simple Test of theEffect of Exchange Rate Defense”Discussants: Shin-ichi Fukuda, andShigenori Shiratsuka, Bank of Japan

Paolo Pesenti, “Shocks, Reforms, andMonetary Rules: A Scenario Analysisfor Japan”Discussants: Kazuo Ueda, Universityof Tokyo, and Tsutomu Watanabe,Hitotsubashi University

Richard Portes, London BusinessSchool and NBER; EliasPapaioannou; and GregoriosSiourounis, Barclays Capital,“Optimal Currency Shares inInternational Reserves: The Impact of the Euro and the Prospects for theDollar”Discussants: Takeo Hoshi andTakatoshi Ito

Mark Spiegel; Takeshi Kobayashi,Chukyo University; and NobuyoshiYamori, Nagoya University,“Quantitative Easing and JapaneseBank Equity Values”Discussants: Naohiko Baba, Bank ofJapan, and Itsuhiro Fukao, KeioUniversity

Andrew K. Rose, “Size Really Doesn’tMatter: In Search of a National ScaleEffect”Discussants: Allan Drazen and EtsuroShioji

18th Annual TRIO Conference


Shioji analyzes the relationshipbetween East Asia’s choice of currencyregime and the transmission of foreignshocks to this area. He develops a three-country model that consists of EastAsia, Japan, and the United States, inthe tradition of the “new open econo-my macroeconomics” literature. Usingnumerical simulations, Shioji derives theoptimal weight attached to the Japaneseyen in East Asia’s currency basket, towhich this region pegs its own currency;optimality is defined with respect to sta-bilization of its trade balance (or othermeasures). In particular, this paper takesinto account the reality that most inter-national transactions are invoiced in theU.S. dollar, and asks how incorporatingthat fact into the model changes theconclusion about the optimal basketweights.

For many developing countries,financial globalization does not auto-matically lead to improvement.According to the literature, there is athreshold effect: only countries thathave met a minimum set of conditions,such as having attained reasonable con-trol of corruption and a certain level ofrule of law, can expect to benefit signif-icantly from financial globalization.And, there is a composition effect: for-eign direct investment (FDI), and per-haps portfolio inflows, are likely to bemore beneficial and less volatile thaninternational bank lending, while totalcapital flows — the sum of all types ofcapital flows — may not have a strongpositive effect on the recipient coun-tries’ rates of growth and their con-sumption risk sharing. Further, thethreshold and composition effects canbe two sides of the same coin, as betterinstitutional quality in a capital-import-ing country may lead to a more favor-able composition of capital inflows forthat country (Wei, 2000b, 2001; Wei andWu, 2002; and Faria and Mauro, 2004).But the earlier literature did not disen-tangle the possibly different effects of

financial development and the quality ofbureaucratic institutions. Wei showsthat these effects can indeed be differ-ent. In particular, bad public institutions( reflected, for example, in a higher levelof bureaucratic corruption) stronglydiscourage FDI, and possibly foreigndebt, in the shares of a country’s totalforeign liabilities, but appear to encour-age the relative prominence of borrow-ing from foreign banks. In comparison,low financial sector development dis-courages inward portfolio equity flowsbut encourages inward FDI. Therefore,views on the connection betweendomestic institutions and the structureof international capital flows must benuanced. To gain confidence that thedocumented data patterns reflect causalrelations, Wei uses instrumental vari-ables for the institutional measuresbased on the economic histories of thecountries in his sample (in particular,the mortality rate of earlier Europeansettlers and the origin of legal systems).The instrumental variables approachbolsters the case that bad institutionsare a cause of unfavorable compositionof capital inflows.

Ito and Hashimoto examine intra-day patterns of exchange rate behavior,using the “firm” bid-ask quotes andtransactions of JPY-USD and Euro-USD pairs recorded in the electronicbroking system of the spot foreignexchanges. First, activities of quotesand transaction volumes are high in thebeginning hours of the three major cur-rency markets — Tokyo, London, andNew York — and low during the Tokyoand London lunch hours and late after-noon in New York. The U-shape ofintra-day activities only occurs amongTokyo and London participants.Second, activities do not increasetoward the end of business hours in theNew York market, even on Fridays(ahead of weekend hours of non-trad-ing). Third, an average bid-ask spread isnarrow (wide), when quote and deal fre-

quencies are high (low, respectively),except for the beginning hour of Tokyo(GMT 0), when the bid-ask spread isideal despite high levels of activity.

Fukuda and Ono investigate thechoice of invoice currency underexchange rate uncertainty. Their analysisis motivated by the fact that the U.S.dollar has been the dominant vehiclecurrency in developing countries. Theirtheoretical analysis is based on an open-economy model of monopolistic com-petition. The export prices are setbefore exchange rates are known. Whenthe market is competitive enough, theexporting firms tend to set their pricesso as not to deviate from those of thecompetitors. As a result, a coordinationfailure can lead the third currency to bean equilibrium invoice currency. Sincemultiple equilibriums are Pareto ranked,this implies that the equilibrium choiceof the invoice currency may lead to aless efficient equilibrium. The role ofexpectations is important in the staticframework. However, in the staggeredprice-setting framework, historybecomes another key determinant ofthe equilibrium currency pricing. Therole of history becomes conspicuouswhen the firms discount future profits,particularly in the competitive localmarket. The result suggests that bothhistory and expectations explain whythe firm tends to choose the U.S. dollaras vehicle currency.

High interest rates used to defendthe exchange rate signal that a govern-ment is committed to fixed exchangerates, but may also signal weak funda-mentals. Drazen and Hubrich test theeffectiveness of the interest ratedefense by disaggregating it into theeffects on future interest rate differen-tials, expectations of future exchangerates, and risk premiums. While muchprevious empirical work has beeninconclusive because of offsettingeffects, tests that “disaggregate” theeffects provide significant information.


Raising overnight interest ratesstrengthens the exchange rate over theshort-term, but also leads to an expect-ed depreciation at a horizon of a yearand longer and an increase in the riskpremium, consistent with the argumentthat it also signals weak fundamentals.

Using a two-country general equi-librium model calibrated to the Japaneseeconomy vis-à-vis the rest of the world,Pesenti simulates the macroeconomictransmission of demand and supplyshocks contingent on whether or notthe zero interest floor (ZIF) is bindingin monetary policy. First, he shows thatnegative demand shocks have moreprolonged and startling effects on theeconomy when the ZIF is binding thanduring normal times when it is notbinding. Next, he illustrates how posi-tive supply shocks that raise potentialoutput (such as structural reforms) canactually extend the period of time overwhich the ZIF may be expected to bind,and therefore make the economy moresensitive to negative demand shocks.Finally, he focuses on the problemsassociated with inflation-targeting rulesand the advantages of policy rules thatinclude price-level-path targeting, bothin a deflationary environment and innormal times when the ZIF is not bind-ing.

Foreign exchange reserve accumu-lation has risen dramatically over thepast five years. The introduction of theeuro and the increased liquidity in othermajor currencies has increased the pres-sure on central banks to diversify awayfrom the dollar. This could have sub-

stantial implications for the internation-al financial system. Papaioannou,Portes, and Siourounis use a mean-variance framework to estimate optimalweights among the main internationalcurrencies and to assess how the eurohas changed this allocation over time.They also incorporate rebalancing costs,which they proxy with (mean andextreme) currency bid-ask spreads. Theresults indicate that the recent drop ineuro spreads fully compensated for thediversification losses associated withfewer currencies. The authors then per-form some simple simulations for theoptimal currency allocation of fourlarge emerging market countries(Russia, Brazil, China and India) incor-porating a central bank’s desire to holda sizable portion of its portfolio in thecurrencies of its foreign debt and inter-national trade. The constrained opti-mization suggests that the euro poten-tially rivals the dollar as an internationalreserve currency. Actual dollar alloca-tions are far greater than the optimizerimplies, consistent with the currentdominant role of the dollar as a reservecurrency. But the increased tendency ofmany developing countries to issueeuro-denominated assets and trade withthe euro zone may shift this equilibriumand put pressure on the dollar.

One of the primary motivationsoffered by the Bank of Japan (BOJ) forits quantitative easing program —whereby it maintained a current accountbalance target in excess of requiredreserves, effectively pegging short-terminterest rates at zero — was to maintain

credit extension by the troubledJapanese financial sector. Kobayashi,Spiegel, and Yamori conduct an eventstudy concerning the anticipated impactof quantitative easing on the Japanesebanking sector by examining the impactof the introduction and expansion ofthe policy on Japanese bank equity val-ues. They find that excess returns ofJapanese banks were greater whenincreases in the BOJ current accountbalance target were accompanied by“non-standard” expansionary policies,such as raising the ceiling on BOJ pur-chases of long-term Japanese govern-ment bonds. The authors also providecross-sectional evidence that suggeststhat the market perceived that the quan-titative easing program would dispro-portionately benefit financially weakerJapanese banks.

Rose searches for a “scale” effectin countries. He uses a panel data setthat includes 200 countries over fortyyears and links the population of acountry to a host of economic andsocial phenomena. Using both graphicaland statistical techniques, he searchesfor an impact of size on the level ofincome, inflation, material well-being,health, education, the quality of a coun-try’s institutions, heterogeneity, and anumber of different internationalindices and rankings. He has little suc-cess; small countries are more open tointernational trade than large countries,but are not systematically different otherwise.


Science Watch, the bimonthlynewsletter of Thomson Scientific,named the NBER as the institutionwith the most cited publications in eco-nomics and business. The NBER alsoranked third in “citation impact” asmeasured by the number of citations

per paper. These rankings are based onthe number of published papers cited innearly 200 journals in economics, busi-ness, and accounting and managementthat are indexed by Thomson Scientific,and on citations per paper.

With more than 30,000 citations

between 1995 and April 2005, theNBER was the most mentioned institu-tion in the field of economics and busi-ness. Based on these figures, ScienceWatch delared that the NBER is one ofthe most influential institutions in busi-ness and economics.

Bureau News

Science Watch Ranks NBER First in Citations

NBER’s Program on MonetaryEconomics met in Cambridge onNovember 4. NBER ResearchAssociates Michael D. Bordo ofRutgers University and Julio J.Rotemberg of MIT organized themeeting. The following papers werediscussed:

Gauti Eggertsson, Federal ReserveBank of New York, “Great Expecta-tions and the End of the Great De-pression”Discussant: Hugh Rockoff, RutgersUniversity

Michael D. Bordo, ChristopherErceg, Andrew Levin, and RyanMichaels, Federal Reserve Board,

“Three Great American Disinflations”Discussant: Francois Velde, FederalReserve Bank of Chicago

Refet Gurkanak, Bilkent University;Andrew Levin; and Eric Swanson,Federal Reserve Bank of SanFrancisco, “Does Inflation TargetingAnchor Long-Run Inflation Expecta-tions? Evidence from Long-TermBonds Yields in the U.S., U.K., andSweden”Discussant: Kenneth Kuttner, Ober-lin College

Timothy Cogley, University ofCalifornia, Davis, and ArgiaSbordone, Federal Reserve Bank ofNew York, “A Search for a Structural

Phillips Curve”Discussant: Jean Boivin, ColumbiaUniversity

Igor Livshits and James Macgee,University of Western Ontario; andMichele Tertilt, Stanford University,“Accounting for the Rise in ConsumerBankruptcies”Discussant: Stephen Zeldes, Colum-bia University

Lutz Kilian, University of Michigan,“Exogenous Oil Supply Shocks: HowBig Are They and How Much DoThey Matter for the U.S. Economy?”Discussant: Ana Maria Herrera,Michigan State University

Monetary Economics

Eggertsson argues that the recov-ery from the Great Depression wasdriven by a shift in expectations. Thisshift was caused by President FranklinDelano Roosevelt’s (FDR) policyactions. On the monetary policy side,FDR abolished the gold standard and— even more importantly —announced an explicit policy objectiveof inflating the price level to pre-Depression levels. On the fiscal policy

side, FDR expanded government realand deficit spending, making his policyobjective credible. Eggertsson evalu-ates the economic consequences ofFDR; he uses a dynamic stochasticgeneral equilibrium model, assumingsticky prices and rational expectations.

In their paper, Bordo and his co-authors examine three famousepisodes of disinflation (or deflation)in U.S. history, including episodes fol-

lowing the Civil War, World War I, andthe Volcker disinflation of the early1980s. For each of these episodes, theyderive measures of policy predictabili-ty that attempt to quantify the extentto which each deflation was anticipatedby economic agents. They use theirmeasures to help account for the dis-parate real effects observed acrossepisodes, and in turn relate them to thepolicy actions and communication


strategy of the monetary authority.They then proceed to account for thesalient features of each episode withinthe context of a stylized model. Theirsimulations indicate how a more pre-dictable policy of gradual deflationcould have helped avoid the sharp post-WWI depression. But the simulationsalso suggest that securing the benefitsof gradualism requires a supportinginstitutional framework and communi-cation strategy that allows the privatesector to make reliable inferences aboutthe course of policy.

Gürkaynak, Levin, and Swansoninvestigate the extent to which inflationtargeting helps anchor long-run infla-tion expectations by comparing thebehavior of daily bond yield data in theUnited Kingdom and Sweden, bothinflation targeters, to that in the UnitedStates, a non-inflation-targeter. Usingthe difference between far-ahead for-ward rates on nominal and indexedbonds as a measure of compensationfor expected inflation and inflation riskat long horizons, the authors examinethe extent to which far-ahead forwardinflation compensation moves inresponse to macroeconomic data releas-es and monetary policy announcements.In the United States, forward inflationcompensation exhibits highly signifi-cant responses to economic news. Inthe United Kingdom, there is a level ofsensitivity similar to that in the UnitedStates prior to the Bank of Englandgaining independence in 1997, but astriking absence of such sensitivitysince the central bank became inde-pendent. In Sweden, inflation compen-sation has been insensitive to economicnews over the whole period for whichthe authors have data. The authorsshow that these results also are matchedby the times-series behavior of far-ahead forward interest rates and infla-tion compensation over this period. Allof these findings suggest that a knownand credible inflation target significant-

ly helps to anchor the private sector’sviews of the distribution of long-runinflation outcomes.

The foundation of the NewKeynesian Phillips curve is a model ofprice setting with nominal rigidities thatimplies that the dynamics of inflationare well explained by the evolution ofreal marginal costs. Cogley andSbordone attempt to analyze whetherthis is a structurally invariant relation-ship. To assess this, they first estimatean unrestricted time-series model forinflation, unit labor costs, and othervariables, and present evidence thattheir joint dynamics are well represent-ed by a vector autoregression with drift-ing coefficients and volatilities, as inCogley and Sargent (2004). Then, fol-lowing Sbordone (2002, 2003), theyapply a two-step minimum distanceestimator to estimate deep parameters.Based on their results, they argue thatthe price-setting model is structurallyinvariant.

Personal bankruptcies in the UnitedStates have increased dramatically, risingfrom 1.4 per thousand working agepopulation in 1970 to 8.5 in 2002.Livshits, MacGee, and Tertilt use aheterogeneous agent life-cycle modelwith competitive financial intermedi-aries who can observe households’earnings, age, and current asset holdingsto evaluate several commonly offeredexplanations. They find that an increasein uncertainty (income shocks, expenseuncertainty) cannot quantitativelyaccount for the rise in bankruptcies.Instead, stories related to a change inthe credit market environment are moreplausible. In particular, a combinationof a decrease in the credit market trans-actions cost together with a decline in“stigma” does a good job at accountingfor the rise in consumer bankruptcy.The authors also argue that the aboli-tion of usury laws and other legalchanges have played little role.

Since the oil crises of the 1970s,

there has been strong interest in thequestion of how oil production short-falls caused by wars and other exoge-nous political events in OPEC countriesaffect oil prices, U.S. real GDP growth,and U.S. CPI inflation. Kilian focuseson the modern OPEC period since1973. His results differ along a numberof dimensions from the conventionalwisdom. First, he shows that under rea-sonable assumptions, the timing, mag-nitude, and even the sign of exogenousoil supply shocks may differ greatlyfrom current state-of-the-art estimates.Second, the common view — that thecase for the exogeneity of at least themajor oil price shocks is strong — issupported by the data for the 1980–1and 1990–1 oil price shocks, but not forother oil price shocks. Notably, statisti-cal measures of the net oil price thatincrease relative to the recent past donot represent the exogenous compo-nent of oil prices. In fact, only a smallfraction of the observed oil priceincreases during crisis periods can beattributed to exogenous oil productiondisruptions. Third, compared to previ-ous indirect estimates of the effects ofexogenous supply disruptions on realGDP growth that treated major oilprice increases as exogenous, the directestimates that Kilian obtains suggest asharp drop after five quarters ratherthan an immediate and sustained reduc-tion in economic growth for a year.They also suggest a spike in CPI infla-tion three quarters after the exogenousoil supply shock rather than a sustainedincrease in inflation, as is sometimesconjectured. Finally, Kilian’s results putinto perspective the importance ofexogenous oil production shortfalls inthe Middle East. He shows that exoge-nous oil supply shocks made remark-ably little difference overall for the evo-lution of U.S. real GDP growth andCPI inflation since the 1970s, althoughthey did matter for some historicalepisodes.


Diabetes is the most common andcostly of all chronic diseases. There isbroad-based agreement on how to man-age the disease, yet fewer than 40 percentof diabetics receive guideline levels ofmedical care. Beaulieu, Cutler, and Hoinvestigate the reasons for this phenome-non by examining the business case forimproved diabetes care from the per-spective of a single health plan(HealthPartners of Minnesota). Thepotential benefits accruing to a healthplan from diabetes disease managementinclude medical care cost savings andhigher premiums. The potential costs tothe health plan derive from disease man-agement program costs and adverseselection. The authors find that theimplementation of diabetes disease man-agement coincided with large healthimprovements. Medical care cost savingsover several years were small in the closedpanel group practice but moderate forthe health plan overall. The difference incost savings between these two patientpopulations could be attributable to scaleor differences in the baseline health ofthe populations. They find evidence thatadverse selection and the timing of cost

and benefits worsen the health plan busi-ness case. In addition, the payment sys-tems, from purchaser to health plan andhealth plan to provider, are very weaklyconnected to the quality of diabetes carefurther weakening the business case.Finally, overlapping provider networkscreate a public goods externality that lim-its the health plan’s ability to privatelycapture the benefits from its investments.

Malpractice premiums are higher insome states than in others for apparentlysimilar physician practices. They are ris-ing, and they are rising at different rates.Someone clearly is paying more into thehealth care or health insurance system,but who? In the first instance, obviouslyphysician practices pay the malpracticepremium, but they may be able to shiftsome or all of high or growing premiumsonto insurers and patients. The questionof the “incidence” of premiums is animportant part of understanding how thesystem behaves and has been behavingover time. An answer to this questionwould also help in judging the distribu-tion of gains and losses from efforts toconstrain premiums or damage awards. Ifall the gain from lower premiums goes to

physicians, public attitudes may be differ-ent than if it is shared with the public.Pauly, Thompson, Abbott, Sage, andMargolis report on a study of premiumincidence over the period 1994-2002,when the malpractice insurance systemagain went into “crisis” as premiums rosesignificantly in some geographic areasand for some kinds of physicians.

Shen and Melnick take a historicalperspective in examining the effects ofmanaged care growth and hospital com-petition on hospital cost and revenuegrowth. Looking at managed care’s boomperiod (1990-4), its mature period (1994-8), and its backlash period (1998-2003),they find that higher managed care pres-ence was indeed effective in slowingdown hospital cost and revenue growthduring the boom and the mature periods.However, it lost its cost containmenteffect during the backlash period. Thisresult persists under different estimationmethods designed to reduce biases thatmight result from omitted variable biasand measurement errors. On the otherhand, competition effects appear to per-sist throughout the three periods. Suchpersistent competition effects were ini-

The NBER’s Health CareProgram met in Cambridge onNovember 4. NBER ResearchAssociate David M. Cutler, ofHarvard University, and ProgramDirector Alan M. Garber, of StanfordUniversity, organized the meeting.These papers were presented:

Nancy Beaulieu, Harvard Universityand NBER; David M. Cutler; andKatherine Ho, Columbia Universityand NBER, “The Business Case forDiabetes Disease Management at TwoManaged Care Organizations”

Mark Pauly, University ofPennsylvania and NBER; ChristyThompson, Independence BlueCross; Thomas Abbott, Medstat, Inc.;William Sage, Columbia University;and James Margolis, Medical GroupManagement Association, “Who Pays:the Incidence of Higher MalpracticePremiums”

Yu-chu Shen, Naval PostgraduateSchool and NBER; and GlennMelnick, University of SouthernCalifornia, “Is Managed Care Still anEffective Cost Containment Device?”

Dana Goldman, RAND Corporationand NBER; Pinar Karaca-mandicand Geoffrey Joyce, RANDCorporation; and Neeraj Sood,RAND Corporation and NBER,“Adverse Selection in Retiree Prescrip-tion Drug Plans”

Ernst R. Berndt, MIT and NBER;Alisa S. Busch and Sharon-liseNormand, Harvard University; andRichard G. Frank, Harvard Universityand NBER, “Real Output in MentalHealth Care During the 1990s” (NBERWorking Paper No. 11557)

Health Care Program Meeting


tially the result of aggressive selectivecontracting in the high managed caremarkets, but were later dominated by theless saturated, but growing, managed caremarkets that seem to catch up with themore developed markets.

Rising co-payments for prescriptiondrugs, coupled with already low rates ofcompliance for chronic therapies, raiseconcerns about the consequences of thedesign of pharmacy benefits. Goldman,Karaca-mandic, Joyce, and Sood con-sider one innovative such benefit bywhich patients with the greatest thera-peutic benefit from a prescription drughave lower co-payments. Patients oftendo not fully internalize future medicalbenefits of a drug therapy and hence donot use the drug optimally. Better priceincentives (through lower co-payments)to patients with higher potential efficacywould encourage optimal compliance

and could lead to future health plan sav-ings in terms of avoided health servicesutilization. The authors model such a co-payment scheme for one of the largestclasses of prescription drugs: cholesterol-lowering (CL) therapy. Using claims datafrom 88 health plans, they study 62,274patients aged 20 and older who initiatedCL therapy between 1997 and 2001.They examine the association betweenco-payments and compliance in the yearfollowing initiation of therapy, and theassociation between compliance and sub-sequent hospital and emergency depart-ment service use for up to four years fol-lowing initiation. They use the results tosimulate the effects of co-payments thatvary depending on a patient’s risk of car-diovascular events. They show that strate-gically reducing co-payments for patientsmost at-risk can improve overall compli-ance and reduce use of other expensive

services. In an era of consumer-directedhealth care and improved informationtechnology, tailoring co-payments to theexpected therapeutic benefit of a patientcan increase the clinical and economicefficacy of prescription medications.

Health accounts document changesover time in the level and composition ofhealth spending. There has been a con-tinued evolution in the ability to tracksuch outlays. Less rapid has been the abil-ity to interpret changes in spending.Berndt, Busch, Frank and Normandapply quality-adjusted price indexes forseveral major mental disorders to nation-al mental health account estimates toassess changes in real “output”. Theyshow that using the new price indexesreveals large gains in real output relativeto application of BLS indexes.

The NBER’s Working Group onMacroeconomics and IndividualDecisionmaking met in Cambridge onNovember 5. Working GroupDirectors George A. Akerlof,University of California, Berkeley, andRobert J. Shiller, NBER and YaleUniversity, set the following agenda:

Nabil Al-najjar, Sandeep Baliga,and David Besanko, NorthwesternUniversity, “The Sunk Cost Bias andManagerial Pricing Practices”Discussant: Truman Bewley, YaleUniversity

William T. Dickens, BrookingsInstitution; Lorenz Goette,University of Zurich; Erica L.

Groshen, Federal Reserve Bank ofNew York; Steinar Holden,University of Oslo; Julian Messina,Jarkko Turunen, and MelanieWard, European Central Bank; andMark E. Schweitzer, FederalReserve Bank of Cleveland, “TheInteraction of Labor Markets andInflation: Analysis of Micro Datafrom the International Wage Flexibil-ity Project”Discussant: Ricardo Reis, PrincetonUniversity and NBER

Refet S. Gürkaynak, Bilkent Uni-versity, and Justin Wolfers, Univer-sity of Pennsylvania and NBER,“Macroeconomic Derivatives: An Ini-tial Analysis of Market-Based Macro

Forecasts, Uncertainty and Risk”Discussant: Paul Willen, FederalReserve Bank of Boston

Ricardo J. Caballero, MIT andNBER, and Arvind Krishnamurthy,Northwestern University, “FinancialSystem Risk and Flight to Quality”Discussant: Jon Faust, FederalReserve Board

Annamaria Lusardi, DartmouthCollege and NBER, and Olivia S.Mitchell, University of Pennsylvaniaand NBER, “Financial Literacy andPlanning: Implications for RetirementWell-Being”Discussant: Andrew Caplin, NewYork University and NBER

Macroeconomics and Individual Decisionmaking

Al-Najjar, Baliga, and Besankoprovide an explanation for why the

sunk cost bias persists among firmscompeting in a differentiated product

oligopoly. Firms experiment with costmethodologies that are consistent with


real-world accounting practices, includ-ing ones that allocate fixed and sunkcosts to determine variable costs. Thesefirms follow naive adaptive learning toadjust prices. Costing methodologiesthat increase profits are reinforced. Theauthors show that all firms eventuallydisplay the sunk cost bias. For thecanonical case of symmetric lineardemand, they obtain comparative staticsresults showing how the degree of thesunk cost bias changes with demand.

The adoption of explicit or implic-it inflation targets by many centralbanks, and the low stable rates of infla-tion that have ensued, raise the questionof how inflation affects market efficien-cy. Dickens, Goette, Groshen,Holden, Messina, Schweitzer,Turunen, and Ward study three marketimperfections that cause the rate ofinflation to affect labor market efficien-cy. First, the presence of substantialresistance to nominal wage cuts in a lowinflation environment can slow theadjustment of relative wages to labormarket shocks and thus result in a mis-allocation of resources. Alternatively, tothe extent that the downward rigidityprevents real wage cuts, rather thannominal wage cuts, inflation will notimprove efficiency. In this case, onlyincreases in real wages resulting fromproductivity growth can reduce the mis-allocation of resources caused by a realwage floor. Higher inflation is associat-ed with more frequent wage and pricechanges, higher search costs for goodsor jobs, and greater uncertainty aboutthe future path of wages and prices.These effects can lead to errors andadjustment lags in wage setting anddiminish the information value ofobserved wages. Thus, increased infla-tion may also cause a misallocation ofresources. In short, inflation can greasethe wheels of economic adjustment inthe labor market by relieving the con-straint imposed by downward nominalwage rigidity, but not if there is also

substantial downward real wage rigidity.At the same time, inflation can throwsand in the wheels of economic adjust-ment by degrading the value of pricesignals. Knowledge of which of theseimperfections dominates at differentlevels of inflation and under differentinstitutional regimes can be valuable forchoosing an inflation target and forlearning more about the economic envi-ronment in which monetary policy isconducted. The authors briefly reviewthe empirical literature in order to moti-vate the method used to distinguishthese three labor market imperfections.Next, they describe the data and empir-ical approach which applies a commonprotocol to 31 distinct panels of work-ers wage changes. Then they establishthat wage changes show substantial dis-persion that rises with the rate of wageinflation, as predicted by grease andsand effects. To identify the threeimperfections under consideration, theyexamine histograms of wage changes(that are corrected for measurementerrors) for the particular asymmetriesand spikes that are characteristic ofdownward real and nominal wage rigid-ity. This process yields estimates of theprevalence of real and nominal wagerigidity for each dataset and year, whichthey then analyze for insight into thecauses and consequences of wagerigidities. Finally, they examine the link-age between estimates of true wagechange dispersion and inflation for evi-dence of sand effects.

In September 2002, a new marketin “Economic Derivatives” waslaunched allowing traders to take posi-tions on future values of several macro-economic data releases. Gürkaynakand Wolfers provide an initial analysisof the prices of these options. Theyfind that market-based measures ofexpectations are similar to survey-basedforecasts although the market-basedmeasures somewhat more accuratelypredict financial market responses to

surprises in data. These markets alsoprovide implied probabilities of the fullrange of specific outcomes, allowingthe authors to measure uncertainty,assess its driving forces, and comparethis measure of uncertainty with thedispersion of point-estimates amongindividual forecasters (a measure of dis-agreement). They also assess the accura-cy of market-generated probability den-sity forecasts. A consistent theme is thatfew of the behavioral anomalies presentin surveys of professional forecasts sur-vive in equilibrium, and that these mar-kets are remarkably well calibrated.Finally, they assess the role of risk, find-ing little evidence that risk-aversiondrives a wedge between market pricesand probabilities in this market.

Caballero and Krishnamurthypresent a model of flight to qualityepisodes that emphasizes financial sys-tem risk and the Knightian uncertaintysurrounding these episodes. In themodel, agents are uncertain about theprobability distribution of shocks inmarkets different from theirs, treatingsuch uncertainty as Knightian. Aversionto Knightian uncertainty generatesdemand for safe financial claims. It alsoleads agents to require financial inter-mediaries to lock-up capital to covertheir own markets’ shocks in a mannerthat is robust to uncertainty over othermarkets, but is wasteful in the aggre-gate. Locked collateral cannot moveacross markets to offset negative shocksand hence can trigger a financial accel-erator. A lender of last resort canunlock private capital markets to stabi-lize the economy during these periodsby committing to intervene should con-ditions worsen.

Some recent evidence suggests thatmany American households will not beable to maintain their lifestyles in retire-ment. Little is known about why peoplefail to plan for retirement, and whetherplanning and information costs mightaffect retirement saving patterns. To


better understand these issues, Lusardiand Mitchell devised and fielded a pur-pose-built module on planning andfinancial literacy for the 2004 Healthand Retirement Study (HRS). Thismodule measures how workers maketheir saving decisions, how they collectthe information for making these deci-sions, and whether they possess thefinancial literacy needed to make thesedecisions. The resulting analysis showsthat financial illiteracy is widespreadamong older Americans: only half ofthe age 50+ respondents could correct-ly answer two simple questions regard-ing interest compounding and inflation,

and only one-third understood these aswell as stock market risk. Women,minorities, and those without a collegedegree were particularly at risk of dis-playing low financial knowledge. Theauthors also evaluate whether peopletried to figure out how much they needto save for retirement, whether theydevised a plan, and whether they suc-ceeded at the plan. In fact, these calcu-lations prove to be difficult: fewer thanone-third of our age 50+ respondentsever tried to devise a retirement plan,and only two-thirds of those who tried,actually claim to have succeeded.Overall, fewer than one-fifth of the

respondents believed that they engagedin successful retirement planning. Theauthors also find that financial knowl-edge and planning are clearly interrelat-ed: those who displayed financialknowledge were more likely to plan andto succeed in their planning. Moreover,those who did plan were more likely torely on formal planning methods suchas retirement calculators, retirementseminars, and financial experts, and lesslikely to rely on family/relatives or co-workers. Finally, Lusardi and Mitchellshow that keeping track of spendingand budgeting habits appears conduciveto retirement saving.

The NBER’s Program on AssetPricing met in Cambridge onNovember 11. Jessica Wachter,NBER and The Wharton School, andLuis M. Viceira, Harvard BusinessSchool, organized the meeting. Thefollowing papers were discussed:

Bernard Dumas, INSEAD andNBER, and Alexander Kurshev andRaman Uppal, London BusinessSchool, “What Can Rational InvestorsDo About Excessive Volatility andSentiment Fluctuations?”Discussant: Leonid Kogan, MIT andNBER

Lubos Pastor and Pietro Veronesi,University of Chicago and NBER,“Technological Revolutions and StockPrices”Discussant: Markus Brunnermeier,Princeton University and NBER

Jun Pan, MIT and NBER, andKenneth Singleton, StanfordUniversity and NBER, “Default andRecovery Implicit in the TermStructure of Sovereign CDS Spreads”Discussant: Francis Longstaff, Univer-sity of California, Los Angeles andNBER

Ravi Bansal and Ed Fang, DukeUniversity, and Amir Yaron, Universityof Pennsylvania and NBER, “EquityCapital: A Puzzle?”Discussant: John Heaton, University ofChicago and NBER

Borja Larrain, Federal Reserve Bankof Boston, and Motohiro Yogo,University of Pennsylvania, “DoesFirm Value Move Too Much to beJustified By SubsequentChanges inCash Flow?”Discussant: Malcolm Baker, Harvard

University and NBER

Jacob Boudoukh, MatthewRichardson, and Robert Whitelaw,New York University and NBER, “TheMyth of Long-Horizon Predictability”

Amit Goyal, Emory University, andIvo Welch, Brown University andNBER, “A Comprehensive Look at theEmpirical Preformance of EquityPremium Prediction”

John Y. Campbell, Harvard Univer-sity and NBER, and Samuel B.Thompson, Harvard University, “Pre-dicting the Equity Premium Out ofSample: Can Anything Beat the His-torical Average?”(NBER Working Pa-per No. 11468)Discussant for all three papers: JohnCochrane, University of Chicago andNBER

Asset Pricing

Dumas, Kurshev, and Uppal ana-lyze the trading strategy that wouldallow an investor to take advantage of

“excessive” stock price volatility and“sentiment” fluctuations. They con-struct a general equilibrium model of

sentiment. In it, there are two classes ofagents; stock prices are excessivelyvolatile because one class is overconfi-


dent about a public signal. As a result,this class of irrational agents changes itsexpectations too often, sometimes beingexcessively optimistic, sometimes beingexcessively pessimistic. The authorsdetermine and examine the trading strat-egy of the rational investors who are notoverconfident about the signal. They findthat, because irrational traders introducean additional source of risk, rationalinvestors reduce the proportion ofwealth invested into equity, except whenthey are extremely optimistic aboutfuture growth. Moreover, their optimalportfolio strategy is based not just on acurrent price divergence but also on amodel of irrational behavior and a pre-diction concerning the speed of conver-gence. Thus, the portfolio strategyincludes a protection in case there is adeviation from that prediction. Theauthors find that long maturity bonds arean essential accompaniment of equityinvestment, as they serve to hedge this“sentiment risk.” Even though rationalinvestors find it beneficial to trade ontheir belief that the market is excessivelyvolatile, the answer to the question posedin the title is: “There is little that rationalinvestors can do optimally to exploit, andhence eliminate, excessive volatility,except in the very long run.”

During technological revolutions,stock prices of innovative firms tend toexhibit high volatility and bubble-like pat-terns, which are often attributed toinvestor irrationality. Pastor andVeronesi develop a general equilibriummodel that rationalizes the observedprice patterns. High volatility is a result ofhigh uncertainty about the average pro-ductivity of a new technology. Investorslearn about this productivity beforedeciding whether to adopt the technolo-gy on a large scale. For technologies thatultimately are adopted, the nature ofuncertainty changes from idiosyncratic tosystematic as the adoption becomesmore likely; as a result, stock prices fallafter an initial run-up. This “bubble” in

stock prices is observable ex post butunpredictable ex ante, and it is most pro-nounced for technologies characterizedby high uncertainty and fast adoption.The authors examine stock prices in theearly days of American railroads, andfind evidence consistent with a large-scale adoption of the railroad technologyby the late 1850s.

Pan and Singleton explore in depththe nature of the risk-neutral credit-eventintensities (λQ) that best describe theterm structures of sovereign CD spreads.They examine three distinct families ofstochastic processes: the square-root, log-normal, and three-halves processes. Theirmodels use different specifications ofmean reversions and time-varying volatil-ities to fit both the distributions ofspreads and the variation over time in theshapes of the term structures of spreads.They find that the models imply highlypersistent λQ that are strongly correlatedwith measures of global credit event risksand the VIX index of option-impliedvolatilities. Moreover, the correlationsacross countries of the model-impliedcredit-event intensities are large, andchange with credit-market conditions.There are substantial model-implied riskpremiums associated with unpredictablefuture variation in λQ. The authors showthat the term structure of CD spreadsallows them to separately identify boththe loss rate in the event of default, LQ,and the parameters of the process, λQ.Unconstrained estimates of LQ are muchlower than the values typically assumed inthe financial industry. Finally, to shedlight on the economic consequences ofdiffering levels of LQ or persistence in λQ,the authors explore the sensitivity of theprices of options on CD contracts toalternative settings of the parametersgoverning the default process.

In almost any equilibrium model,shifts in sectoral wealth have direct impli-cations for asset returns, inducinginvestors to hold more or less of theirwealth in the sector. For an expanding

sector, these inducements can be in theform of higher-mean or lower-volatilityassets. Bansal, Fang, and Yaron docu-ment that shifts in sectoral financialwealth have virtually no bearing on thesubsequent mean and volatility of sec-toral returns. About 90 percent of thewealth share fluctuations are attributableto movements in net payout and 10 per-cent to changes in expected returns. Theevidence shows that sectoral wealth andasset returns are not related — this leadsto the equity capital puzzle.

Through the flow-of-funds identityand the capital accumulation equation,Larrain and Yo develop a present-valuemodel that relates the market value ofcorporate assets to its expected futurecash flow. The relevant measure of cashflow is net payout, which is the sum ofdividends, interest, and net equity anddebt repurchases. A variance decomposi-tion of the ratio of net payout to assetsshows that 12 percent of its variation isexplained by asset returns, while 88 per-cent is explained by cash flow growth.The constant discount rate present-valuemodel is adequate for valuing corporateassets, in contrast to its failure for valuingequity.

The prevailing view in finance is thatthe evidence for being able to predictlong-horizon stock returns is significant-ly stronger than for short-horizonreturns. Boudoukh, Richardson, andWhitelaw show that, for all practical pur-poses, the estimators are almost perfectlycorrelated across horizons under the nullhypothesis of no predictability. Forexample, for the persistence levels of div-idend yields, the analytical correlation is99 percent between the 1- and 2-yearhorizon estimators and 94 percentbetween the 1- and 5-year horizons,because of the combined effects of over-lapping returns and persistence of thepredictive variable. Common samplingerror across equations leads to OLS coef-ficient estimates and R-squares that areroughly proportional to the horizon


under the null of no predictability. This isthe precise pattern found in the data.They corroborate the asymptotic theoryand extend the analysis using extensivesimulation evidence. The authors thenperform joint tests across horizons for avariety of explanatory variables, andthere is little or no evidence of pre-dictability in the data.

Economists have suggested a wholerange of variables that predict the equitypremium: dividend price ratios, dividendyields, earnings-price ratios, dividend pay-out ratios, corporate or net issuing ratios,book-market ratios, beta premia, interestrates (in various guises), and consump-tion-based macroeconomic ratios (cay).Goyal and Welch comprehensively reex-

amine the performance of these vari-ables, both in-sample and out-of-sample.They find that most variables would nothave helped an investor outpredict thehistorical equity premium mean. Mostwould have hurt outright. None deservesan unqualified endorsement.

A number of variables are correlatedwith subsequent returns on the aggregateU.S. stock market in the twentieth centu-ry. Some of these variables are stockmarket valuation ratios, others reflect pat-terns in corporate finance or the levels ofshort- and long-term interest rates. Goyaland Welch (2004) have argued that in-sample correlations conceal a systematicfailure of these variables out of sample:none are able to beat a simple forecast

based on the historical average stockreturn. In their paper, Campbell andThompson show that forecasting vari-ables with significant forecasting powerin-sample generally have a better out-of-sample performance than a forecastbased on the historical average return,once sensible restrictions are imposed onthe signs of coefficients and return fore-casts. The out-of-sample predictivepower is small, but they find that it is eco-nomically meaningful. They also showthat a variable is quite likely to have poorout-of-sample performance for anextended period of time even when thevariable genuinely predicts returns with astable coefficient.

The NBER’s Program onCorporate Finance met at theHarvard Business School onNovember 11. Heitor Almeida andDaniel Wolfenzon, NBER and NewYork University Stern School ofBusiness, organized this program:

Viral Acharya, London BusinessSchool, and Rangarajan Sundaramand Kose John, New York University,“Cross-Country Variations in CapitalStructures: The Role of BankruptcyCodes”Discussant: Matias Braun, University ofCalifornia, Los Angeles

Jean Helwege, University of Arizona;Christo Pirinsky, Texas A&M Univer-sity; and Rene Stulz, Ohio StateUniversity and NBER, “Why Do FirmsBecome Widely Held? An Analysis of

the Dynamics of Corporate Owner-ship”Discussant: Randall Morck, NBER andUniversity of Alberta

Amir Sufi, University of Chicago andNBER, “Bank Lines of Credit inCorporate Finance: An EmpiricalAnalysis”Discussant: Murillo Campello,University of Illinois

Marianne Bertrand, University ofChicago and NBER, Francis Kramarz,CREST-ENSAE; Antoinette Schoar,MIT and NBER; and David Thesmar,HEC, “Politically Connected CEOsand Corporate Outcomes: Evidencefrom France”Discussant: Mara Faccio, VanderbiltUniversity

Massimo Massa, INSEAD, andAndrei Simonov, Stockholm Schoolof Economics, “Shareholder Homo-geneity and Firm Value: The Disciplin-ing Role of Non-Controlling Share-holders”Discussant: Martijn Cremers, YaleUniversity

Alexander Dyck, University ofToronto; Natalya Volchkova,Russian-European Center for Eco-nomic Policy; and Luigi Zingales,Harvard University and NBER, “TheCorporate Governance Role of theMedia: Evidence from Russia”Discussant: Stefano Dellavigna, UC,Berkeley

Corporate Finance

Acharya, Sundaram, and Johninvestigate the impact of bankruptcycodes on firms’ capital-structure

choices. They develop a theoreticalmodel to identify how firm character-istics may interact with the bankruptcy

code in determining optimal capitalstructures. A novel and sharp empiricalimplication emerges from this model:


the difference in leverage choices undera relatively equity-friendly bankruptcycode (such as the U.S. code) and one thatis relatively more debt-friendly (such asthe U.K. code) should be a decreasingfunction of the anticipated liquidationvalue of the firm’s assets. Using a largedatabase of U.S. and U.K. firms over theperiod 1990 to 2002, they subject thisprediction to extensive empirical testing,both parametric and non-parametric,using different proxies for liquidation val-ues and different measures of leverage.They find strong support for the theory;that is, proxies for liquidation value areboth statistically and economically signif-icant in explaining leverage differencesacross the two countries. On the otherhand, many of the other factors that areknown to affect within-country leverage(such as size) cannot explain across-countries differences in leverage.

Helwege, Pirinsky, and Stulz con-sider IPO firms from 1970 to 2001 andexamine the evolution of their insiderownership over time to understand betterwhy and how U.S. firms that becomewidely held did so. In their sample, amajority of firms has insider ownershipbelow 20 percent after ten years. Theauthors find that a firm’s stock marketperformance and trading play anextremely important role in its insiderownership dynamics. Firms that experi-ence large decreases in insider ownershipand/or become widely held have highvaluations, good recent stock market per-formance, and liquid markets for theirstocks. In contrast and surprisingly, vari-ables suggested by agency theory havelimited success in explaining the evolu-tion of insider ownership.

Sufi uses novel data collected fromannual 10-K SEC filings to conduct thefirst large sample empirical examinationof the use of bank lines of credit by pub-lic corporations. He finds that the supplyof lines of credit by banks to corporateborrowers is particularly sensitive to theborrowers’ historical profitability. Even

among borrowers with access to a bankline of credit, banks use strict covenantson profitability, and the borrower losesaccess to the unused portion of the lineof credit when it experiences a drop inprofitability. These findings identify aspecific constraint (the inability to obtaina line of credit) that causes low prof-itability firms to hold larger cash balancesin their liquidity management strategies.

A number of papers have docu-mented that political leaders may usetheir power to grant favors to connectedprivate firms. In this paper, Bertrand,Kramarz, Schoar, and Thesmar investi-gate the reverse perspective: they askwhether politically connected businessleaders alter corporate decisions tobestow “re-election favors” onto incum-bent politicians. They study this questionin the context of France, where they doc-ument a large overlap in educational andprofessional background between theCEOs of publicly-traded firms andpoliticians: more than half of the assetstraded on the French stock markets aremanaged by CEOS who were formerlycivil servants. Overall, the results supportthe hypothesis that connections betweenCEOs and politicians factor into corpo-rate decisions on job creation anddestruction. Firms managed by connect-ed CEOs create more jobs (and destroyfewer plants) in politically more contest-ed areas, and especially around electionyears. The authors find weak evidencethat these networks between politiciansand business executives follow partisanlines. In return, “favors” extended byconnected CEOs to politicians seem tobe reciprocated through privileged accessto subsidy programs and lower taxes.Finally, the authors show that firms man-aged by politically connected CEOs havelower performance than non-connectedfirms, suggesting that political connec-tions might impose a cost on the firms.

Massa and Simonov study how theshareholding structure of a firm affectsits stock price and profitability. They

argue that the degree of shareholderhomogeneity affects firm value.Homogeneous shareholders act as a dis-ciplining device on managers, inducinghigher profitability, higher stock price,lower volatility and higher transparency.Shareholder homogeneity represents analternative and indirect source of corpo-rate governance based on the stock mar-ket. The authors test this hypothesis byusing a dataset containing information onall the shareholders for each firm inSweden from 1995 to 2001. They con-struct two novel proxies for shareholderhomogeneity: the first is based on the agecohort of the shareholders, and the sec-ond on their degree of college interac-tion. For each firm, they measure thedegree of homogeneity of all sharehold-ers. Using this proxy, they show thatgreater homogeneity increases firm prof-itability and returns, and reduces analysterror, analyst dispersion, and stockvolatility.

Dyck, Volchkova, and Zingalesstudy the effect of media coverage oncorporate governance outcomes byfocusing on Russia in the period 1999—2002. Russia provides multiple examplesof corporate governance abuses, wheretraditional corporate governance mecha-nisms are ineffective, and where they canidentify an exogenous source of newscoverage arising from the presence of aninvestment fund, the Hermitage fund,that tried to shame companies by expos-ing their abuses in the internationalmedia. The authors find that the proba-bility that a corporate governance abuseis reversed is affected by the coverage ofthe news in the Anglo-American press.The result is not attributable to the endo-geneity of news reporting, since thisresult holds even when they instrumentmedia coverage with the presence of theHermitage fund among its shareholdersand the “natural” newsworthiness of thecompany involved. They confirm thisevidence with a case study.


Persuasion is a fundamental part ofsocial activity, yet it is rarely studied byeconomists. Mullainathan and Shleifercompare the traditional economicmodel, in which persuasion is an effortto change the listener’s mind using infor-mation, with a behavioral model, inwhich persuasion is an effort to fit themessage into the audience’s already heldbeliefs. They present a simple formaliza-tion of the behavioral model, and com-pare the two models using data on finan-cial advertising in Money and BusinessWeek magazines over the course theinternet bubble. The evidence on thecontent of persuasive messages is broad-ly consistent with the behavioral modelof persuasion.

Baker and Wurgler document thatU.S. government bonds co-move morestrongly with bond-like stocks: stocks oflarge, mature, low-volatility, profitable,dividend-paying firms that are neitherhigh growth nor distressed. This patternmay be caused by common shocks toreal cash flows, rationally requiredreturns, or flights to quality in which

drops in investor sentiment increase thedemand for both government bonds andbond-like stocks. Consistent with boththe required returns and sentiment chan-nels, the authors find a common pre-dictable component in bonds and bond-like stocks. Consistent with the senti-ment channel, they find that bonds andbond-like stocks co-move with inflowsinto government bond and conservativestock mutual funds.

A reduction in inflation can fuelrun-ups in housing prices if people suf-fer from money illusion. For example,basing the decision on whether to rent orbuy a house simply on monthly rent rel-ative to current monthly mortgage pay-ments, agents do not properly take intoaccount that inflation lowers future realmortgage payments, therefore systemati-cally mis-evaluating real estate. Afterempirically decomposing the price-rentratio into a rational component and animplied mispricing, Brunnermeier andJulliard find that: 1) inflation and thenominal interest rate explain a largeshare of the time-series variation of the

mispricing; 2) the run-ups in housingprices starting in the late 1990s can bereconciled with the contemporaneousreduction in inflation and nominal inter-est rates; and 3) the tilt effect cannotrationalize these findings.

Billett and Qian explore the sourceof managerial hubris in mergers andacquisitions by examining the history ofdeals made by individual acquirers. Theirstudy has three main findings: 1) com-pared to their first deals, acquirers ofsecond and higher-order deals experi-ence significantly more negativeannouncement effects; 2) while acquisi-tion likelihood increases in the perform-ance associated with previous acquisi-tions, previous positive performancedoes not curb the negative wealth effectsassociated with future deals; 3) top man-agement’s net purchase of stock isgreater preceding high order deals than itis for first deals. The authors interpretthese results as consistent with self-attri-bution bias leading to managerial over-confidence. They also find evidence thatthe market anticipates future deals based

The NBER’s Working Group onBehavioral Economics, directed byNBER Research Associates Robert J.Shiller of Yale University and RichardH. Thaler, University of Chicago, metin Cambridge on November 12. Thefollowing papers were discussed:

Andrei Shleifer and SendhilMullainathan, Harvard University andNBER, “Persuasion in Finance”Discussant: Shane Frederick, MIT

Jeffrey Wurgler, New York Universityand NBER, and Malcolm Baker,Harvard University and NBER,“Government Bonds and the Cross-Section of Stock Returns”

Discussant: Bhaskaran Swaminathan,Cornell University

Markus Brunnermeier, PrincetonUniversity, and Christian Julliard,London School of Economics,“Money Illusion and HousingFrenzies”Discussant: Christopher J. Mayer,Columbia University and NBER

Yiming Qian and Matthew Billett,University of Iowa, “Are Overconfi-dent Managers Born or Made?Evidence of Self-Attribution Bias fromFrequent Acquirers”Discussant: Ulrike Malmendier, Stan-ford University and NBER

Harrison Hong, Princeton University,and Marcin Kacperczyk, Universityof British Columbia, “The Price of Sin:The Effects of Social Norms onMarkets”Discussant: Owen Lamont, YaleUniversity and NBER

Luigi Guiso, University of Chicago;Paola Sapienza, NorthwesternUniversity and NBER; and LuigiZingales, Harvard University andNBER, “Trusting the StockMarket”(NBER Working Paper No.11648)Discussant: Joshua Coval, HarvardUniversity

Behavioral Economics


on an acquirer’s acquisition history andimpounds such anticipation into stockprices.

Hong and Kacperczyk provideevidence for the effects of social normson markets by studying “sin” stocks —publicly-traded companies involved inproducing alcohol, tobacco, and gaming.They hypothesize that there is a societalnorm to not fund operations that pro-mote vice and that some investors, par-ticularly institutions subject to norms,pay a financial cost in abstaining fromthese stocks. Consistent with thishypothesis, sin stocks are less held bycertain institutions, such as pensionplans (but not by mutual funds who arenatural arbitrageurs), and less followedby analysts than other stocks. Consistent

with them facing greater litigation riskand/or being neglected because of socialnorms, they outperform the market evenafter accounting for well-known returnpredictors. Corporate financing deci-sions and time-variation in norms fortobacco also indicate that norms affectstock prices. Finally, the authors gaugethe relative importance of litigation riskversus neglect for returns. Sin stockreturns are not systematically related tovarious proxies for litigation risk, but areweakly correlated with the demand forsocially responsible investing, consistentwith them being neglected.

Guiso, Sapienza, and Zingalesprovide a new explanation for the limit-ed stock market participation puzzle. Indeciding whether to buy stocks, investors

factor in the risk of being cheated. Theperception of this risk is a function notonly of the objective characteristics ofthe stock, but also of the subjectivecharacteristics of the investor. Less trust-ing individuals are less likely to buy stockand, conditional on buying stock, theywill buy less stock. The calibration of themodel shows that this problem is suffi-ciently severe to account for the lack ofparticipation of some of the richestinvestors in the United States as well asfor differences in the rate of participa-tion across countries. The authors alsofind evidence consistent with thesepropositions in Dutch and Italian micro-data, as well as in cross-country data.

The NBER’s Working Group onHigher Education met in Cambridgeon November 17. Director Charles T.Clotfelter, NBER and DukeUniversity, organized this program:

Jesse Rothstein, Princeton Univer-sity and NBER, and Albert Yoon,Northwestern University, “Mismatchin Law School”Discussant: Thomas J. Kane, HarvardUniversity and NBER

Christopher Cornwell and DavidMustard, University of Georgia,“Merit Aid and Sorting: The Effectsof HOPE-Style Scholarships onCollege Ability Stratification”Discussant: Susan Dynarski, Harvard

University and NBER

Devin Pope, University ofCalifornia, Berkeley, and Jaren Pope,North Carolina State University,“Understanding College ChoiceDecisions: How Sports SuccessGarners Attention and ProvidesInformation”Discussant: Sarah Turner, University

of Virginia and NBER

John J. Siegfried and T. AldrichFinegan, Vanderbilt University, andWendy Stock, Montana State Unive-rsity, “Time-to-Degree for the Eco-nomics PhD Class of 2001–02” and“Attrition in Economics Ph.D. Pro-grams”

Discussant: Ronald G. Ehrenberg,Cornell University and NBER

Scott Carrell, Dartmouth College,and Frederick V. Malmstrom andJames E. West, U.S. Air ForceAcademy, “Peer Effects in AcademicCheating”Discussant: David Zimmerman,Williams College and NBER

Ofer Malamud, University ofChicago, “Breadth vs. Depth: TheEffect of Academic Specialization onLabor Market Outcomes”Discussant: Bruce Sacerdote,Dartmouth College and NBER

Higher Education

According to the “mismatch”hypothesis, affirmative action prefer-ences in admissions induce minoritystudents to attend selective schools

where they are unable to compete withtheir more qualified white classmates.Rothstein and Yoon implement twotests of mismatch using data on law

students. Students attending moreselective law schools earn substantiallylower grades than similarly-qualifiedstudents at less selective schools, but


are no less likely to graduate or pass thebar exam, and obtain better jobs athigher salaries. The authors also com-pare black students to whites. In theupper four quintiles of the LSAT-undergraduate GPA distribution, blacksand whites graduate and pass the barexam at similar rates, though blacksattend more selective schools and earnlower grades; blacks also obtain betterpost-law-school jobs. In the bottomquintile, black bar passage rates arelower. However, this cannot confidentlybe attributed to mismatch, as manymore whites than blacks are unable togain admission to law school, introduc-ing the potential for sample selectionbias.

In the last 15 years there has been asignificant increase in merit aid. Sincethe early 1990s nearly 30 state-spon-sored merit programs have been start-ed, about half of which are based large-ly on Georgia’s HOPE Scholarship.Coincident with this increase in meritaid has been increased attention to sort-ing in various aspects of life, especiallyin education. Cornwell and Mustardexamine the extent to which merit-based aid exacerbates or amelioratessorting by ability in higher education.They use data from Peterson’s Guide toColleges and the Integrated Post-sec-ondary Education Data System(IPEDS) to evaluate this relationship.From these sources they create a largepanel dataset of institutions of higherlearning in the Southern RegionalEducation Board (SREB), and test howmerit aid affects sorting between andwithin states. Their empirical strategytreats HOPE as a natural experimentand contrasts the quality of freshmen atGeorgia colleges to their out-of-statecounterparts. The difference-in-differ-ences estimates show that HOPEincreased the quality of entering fresh-men in Georgia institutions relative totheir out-of-state peers. At the highest-quality institutions HOPE raises all

measures of student quality and thehomogeneity of students by ability. Thelowest-quality institutions experienceno statistically significant effect fromHOPE on any measure of student qual-ity. The authors conclude that state-sponsored merit aid programs increasethe retention of high ability students forcollege and also increase the abilitystratification of institutions withinstates. They also examine two indirectmeasures of student selectivity: accept-ance and yield rates. HOPE decreasesacceptance rates at all types of institu-tions, but the percentage change islargest at the universities, which aremost space constrained. HOPE increas-es yield rates for universities but not forany other institution categories. Puttogether, these results suggest thatHOPE substantially increased the selec-tivity at universities. In addition toGeorgia, five other states (Arkansas,Florida, Kentucky, Louisiana, Maryland,and South Carolina) in the SREB start-ed large-scale merit aid programs duringthe sample period. The data show thatin general universities in these statesexperience similar gains in verbal andmath SAT scores and the percentage ofstudents who graduate in the top 10percent of their high school classes.There are two exceptions. Louisiana,which uses a relatively low thresholdcriterion to qualify for its merit award,experiences no statistically significantincrease in SAT scores from its meritprogram. Florida’s Bright FuturesScholarship appears to reduce the SATscores of incoming students whileincreasing the fraction of students whograduated from the top 10 percent oftheir high school classes.

Deciding where to apply to collegeamong the thousands of four-yearschools in the United States is a daunt-ing task for most teenagers. High schoolstudents are typically not aware of all ofthe benefits that each school mightoffer. In fact, observation suggests that

many students may be more familiarwith a school’s recent sports recordthan its academic quality. Pope andPope develop a simple model of schoolchoice that incorporates the limitedawareness that high school studentsmay have regarding the utility of attend-ing different colleges. Their model pre-dicts that college sports success mayincrease a school’s future applicationsboth by making students more aware ofthat college and by increasing the utilityassociated with attending that school.Using an administrative dataset thatrecords where high school students senttheir SAT scores, the authors analyzethe effect of sports success on sent testscores for all 332 schools that partici-pate in NCAA Division I basketball orfootball. They show that sent test scoresact as a reasonable proxy for sent appli-cations. Their results indicate thatsports success in a given year canincrease the total number of studentsthat send their test scores the followingyear by up to 10 percent. They alsoshow that certain demographic groups(males, blacks, and students who playedsports in high school) are significantlymore influenced by sports success andthat schools can expect changes in senttest scores by up to 15–20 percent aftera good sports year for these groups.The authors conclude that the increasein sent test scores stems from both theincreased exposure/awareness thatschools receive because of sports andthe increased utility that students associ-ate with attending a school with astrong sports program.

Stock and Siegfried use surveyresponses from Ph.D. graduates andthesis advisors to estimate the timerequired for the class of 2001–2 to earna degree. Median time to earn the Ph.D.is 5.5 years, up from 5.25 years for theclass of 1996–7. The time required towrite a dissertation is a little longer thanthe time required to complete compre-hensive examinations and course work.


Graduates who had their first childwhile in a Ph.D. program are estimatedto finish almost one year later than oth-ers. Those with predominantly fellow-ship support finished about six monthsfaster than those funded predominantlyby a teaching assistantship, as did thosewhose dissertation was a set of essaysrather than a single topic treatise.Americans who did their undergraduatework at either a Top-50 U.S. liberal artsor other U.S. college or university thatdoes not offer a Ph.D. in economics fin-ished faster than their counterparts whoearned a bachelor’s degree from a U.S.university that offers a Ph.D. in eco-nomics. International students frompredominantly English speaking coun-tries finished faster than other studentsstudying in the United States on tempo-rary visas.

Stock, Finegan, and Siegfried useinformation about 586 individuals whomatriculated into two economics Ph.D.programs in Fall 2002 to estimate first-and second-year attrition rates. Aftertwo years, 26.5 percent of the initialcohort had left, equally divided betweenthe first and second years. Attritionvaries widely across individual pro-grams. It is lower among the most high-ly rated 15 programs, for students withhigher verbal and quantitative GREscores, and for those on a researchassistantship. Poor academic perform-ance is the most cited reason for with-

drawal. About 15 percent transfer toother economics programs becausethey are dissatisfied with some aspect ofthe particular program where they firstenrolled.

Using self-reported academic honorviolations from the classes of 1959through 2002 at the three major U.S. mil-itary service academies (Air Force, Army,and Navy), Carrell, Malmstrom, andWest measure how peer honesty influ-ences individual cheating behavior. Allelse equal, they find higher levels of peercheating result in a substantiallyincreased probability that an individualwill cheat. They identify through sepa-rate estimation procedures an exogenous(contextual or pre-treatment) peer effectand an endogenous (during treatment)peer effect. Results for the (first-order)exogenous peer effect indicate that oneadditional high school cheater creates0.33 to 0.48 new college cheaters. Resultsfor the (first-order) endogenous peereffect indicate that one additional collegecheater creates 0.61 to 0.86 new collegecheaters. These results imply that, inequilibrium, the social multiplier for aca-demic cheating ranges between 2.56 and3.97.

Malamud examines the tradeoffbetween early and late specialization inthe context of higher education. Whilesome educational systems require stu-dents to specialize early by choosing amajor field of study prior to entering

university, others allow students topostpone this choice. Malamud devel-ops a model in which individuals, bytaking courses in different fields ofstudy, accumulate field-specific skillsand receive noisy signals of match qual-ity in these fields. With later specializa-tion, students have more time to learnabout match quality in each field butless time to acquire specific skills once afield is chosen. Malamud derives com-parative static predictions betweenregimes with early and late specializa-tion, and tests these predictions acrossBritish systems of higher educationusing university administrative data andsurvey data on 1980 university gradu-ates. He finds that individuals inScotland, where specialization occursrelatively late, are less likely to switch toan occupation that is unrelated to theirfield of study compared to theirEnglish counterparts who specializeearlier. According to the model, thereturn to being well matched to anoccupational field is high relative to thereturn to specific skills and there maytherefore be benefits to later specializa-tion. Malamud also finds strong evi-dence in support of the prediction thatindividuals who switch to unrelatedoccupations earn lower wages but noevidence that the cost of switching dif-fers between those specializing earlyand late.


Figlio adopts a novel approach todiscerning one pathway through whichfamily and cultural expectations andresultant identity-formation could influ-ence young women’s choices aboutstudies and potential future careers. Heposits that a girl with a more femininename may be treated systematically dif-ferently by parents, teachers, and peers,or may herself relate to more femininestereotypes. In such a circumstance,girls with more feminine names may bemore likely to select coursework that ismore “traditionally female”— such asthe humanities and foreign languages— and shy away from coursework thatis more “traditionally male” — such asadvanced math and science. Of course,names are not exogenously given togirls. Parents often pay great attentionto the names they give their children,and parents with different proclivitiestoward mathematics and science, say,may systematically select differentnames for their daughters. In order toavoid confounding unmeasured family-specific factors with causal effects ofnames, Figlio uses a unique dataset ofpairs of highly-achieving sisters provid-

ed to him by a large Florida school dis-trict. He then relates the name that agiven high-achieving sister has to herpropensity to take calculus and physicsin high school, as compared with herhigh-achieving sisters with differentnames. Parents often give pairs of sis-ters very different names in terms oftheir femininity, offering the opportuni-ty to directly test the presumption that aname can have causal influences on agirl’s academic development. Figliofinds that girls with more femininenames are less likely to self-select intoadvanced mathematics and scienceclasses in high school, holding constantfamily fixed effects and prior achieve-ment. These results suggest that envi-ronmental factors play a large role indetermining whether women choosemathematics and science as potentialcareers.

Private schools are, on average, athird of the size of public schools. Butwhy are they small? Two possible expla-nations are differences in demand anddifferences in production. If the returnsto scale are similar for private and pub-lic high schools, then an increase in

school choice through private schoolvouchers could lead to larger privatehigh schools. This would be a demandeffect — private schools are smallerbecause fewer people want to go tothem. Using cost estimates for publicschools from Ledyard (2004), Ledyardcan account for approximately 70 per-cent of the difference in size betweenpublic and Catholic high schools. Sheholds costs fixed, and uses data on pri-vate school location, size, and affiliationto predict the size of Catholic schools.

Both public and private two-yearcolleges rely on public subsidies tomake their education affordable for stu-dents. Public community collegesreceive government support directly inthe form of subsidies, while private for-profit colleges or proprietary schoolsreceive government support indirectlyin the form of grants or vouchers givento students. Cellini analyzes the impactof these two funding schemes on theentry decisions of proprietary schoolsand enrollments in community colleges.She uses a new administrative dataset offor-profit colleges in California, paneldata methods, and a unique regression

The NBER’s Education Programmet in Cambridge on November 18.Program Director Caroline M. Hoxby,NBER and Harvard University, chosethe following papers for discussion:

David N. Figlio, University ofFlorida and NBER, “Why Barbie Says‘Math is Hard’”

Margaret Ledyard, University ofTexas at Austin, “ Why are PrivateSchools Small? School Location,Returns to Scale, and Size”

Stephanie Riegg Cellini, Universityof California, Los Angeles, “FundingSchools or Financing Students: PublicSubsidies and the Market for Two-Year College Education”

Joshua Angrist, MIT and NBER,and Aimee Chin, University ofHouston; and Ricardo Godoy,Brandeis University, “Is Spanish-OnlySchooling Responsible for the Puerto-Rican Language Gap?”

Lex Borghans and Bart GolsteynUniversity of Maastrich, “Imagination,

Time Discounting, and Human CapitalInvestment Decisions”

Nora Gordon, University ofCalifornia, San Diego and NBER;Elizabeth Cascio, University ofCalifornia, Davis and NBER; SarahReber, University of California, LosAngeles; and Ethan Lewis, FederalReserve Bank of Philadelphia, “Financial Incentives and the Deseg-regation of Southern Public Schools”

Education Program Meeting


discontinuity design. She finds that anincrease in public funding for a localcommunity college diverts studentsfrom the private to the public sectorand causes a corresponding decline inthe number of proprietary schools inthe county. Raising student financial aidawards, on the other hand, expands theoverall pool of sub-baccalaureate stu-dents and causes proprietary schools toenter the market. This effect is particu-larly strong in counties with high pover-ty rates where more students are eligiblefor aid.

Between 1898 and 1948, Englishwas the language of instruction formost post-primary grades in PuertoRican public schools. Since 1949, thelanguage of instruction in all grades hasbeen Spanish. Angrist, Chin, andGodoy use this policy change to esti-mate the effect of English-intensiveinstruction on the English-languageskills of Puerto Ricans. Although naïveestimates suggest that English instruc-tion increased English-speaking abilityamong Puerto Rican natives, estimatesthat allow for education-specific cohorttrends show no effect. This result is sur-prising in light of the strong presump-tion by American policymakers at thetime that English instruction was the

best way to raise English proficiency. Itsuggests that increased emphasis onusing English as the language ofinstruction may do little to benefitPuerto Ricans who remain on the islandtoday.

While economic theory regardseducation as an important investment,the reality of students’ behavior doesnot always seem to support this view.Borghans and Golsteyn aim to analyzethe behavior of students at college froman investment perspective. They pro-vide robust paradoxical findings thatcollege students with higher discountrates stay longer in education. Theexplanation they pursue is that a higherdiscount rate can partly be a conse-quence of a lack of imagination aboutthe future work life. If so, the discountrate will be very high at moments whenthere are major changes in circum-stances, in this case when students gofrom college to work. This providesincentives for students who lack a clearpicture about their future work-findinglife to stay in education. To test thismodel, the authors measure the crucialindividual attributes, ask students aboutthe way they made their choices, andpresent them other choices that revealthe nature of their behavior. The empir-

ical results support the model, so themain conclusion is that a lack of imagi-nation induces students to stay longer ineducation while it reduces the efficiencyof this investment.

Cascio, Gordon, Lewis, andReber examine whether the financialincentives put in place by two pieces offederal legislation — the Civil RightsAct of 1964 and the Elementary andSecondary Education Act of 1965 —played a causal role in desegregatingsouthern schools. The latter targeted alarge federal education program towardthe South, while the former tied thereceipt of funds under this new pro-gram to nondiscrimination. Using anewly collected dataset on schooldesegregation and school finance forthe 1960s, the authors find that districtswith relatively more to lose under feder-al funding allocation rules engaged inmore student desegregation, were morelikely to have desegregated their facul-ties, and were more likely to havereceived their federal funding by the fallof 1967. Qualitatively similar results arefound for the fall of 1966. These resultssuggest that legislative and executiveenforcement efforts — not just thecourts — contributed to the desegrega-tion of southern education.


Besley, Persson, and Sturm for-mulate a model to explain why the lackof political competition may stifle eco-nomic performance; they use the UnitedStates as a testing ground for the model’spredictions, exploiting the 1965 VotingRights Act which helped to break thenear monopoly on political power of theDemocrats in southern states. They findthat changes in political competitionhave quantitatively important effects onstate income growth, state policies, andquality of Governors. By their bottom-line estimate, the increase in politicalcompetition triggered by the VotingRights Act raised long-run per capitaincome in the average affected state byabout 20 percent.

Drazen and Eslava present a modelof political budget cycles in whichincumbents influence voters by targetinggovernment spending to specific groupsof voters at the expense of other votersor other expenditures. Each voter faces asignal extraction problem: being targetedwith expenditure before the election mayreflect opportunistic manipulation, butmay also reflect a sincere preference ofthe incumbent for the types of spending

that voter prefers. The authors show theexistence of a political equilibrium inwhich rational voters support an incum-bent who targets them with spendingbefore the election even though theyknow it may be electorally motivated. Inequilibrium, voters in the more “swing”regions are targeted at the expense oftypes of spending not favored by thesevoters. This will be true even if theyknow they live in swing regions.However, the responsiveness of thesevoters to electoral manipulation dependson whether they face some degree ofuncertainty about the electoral impor-tance of the group they are in. Use oftargeted spending also implies voters canbe influenced without election-yeardeficits, consistent with recent findingfor established democracies.

Standard intuitions for optimal ger-rymandering involve concentrating one’sextreme opponents in “unwinnable” dis-tricts (“throwing away”) and spreadingone’s supporters evenly over “winnable”districts (“smoothing”). These intuitionsare not robust and depend crucially onarbitrary modeling assumptions.Friedman and Holden characterize the

solution to a problem in which the ger-rymanderer observes a noisy signal ofvoter preferences from a continuous dis-tribution and creates N districts of equalsize to maximize the expected number ofdistricts that she wins. They show that“throwing away” districts is not general-ly optimal, nor is “smoothing.” The opti-mal solution involves creating a districtthat matches extreme “Republicans”with extreme “Democrats,” then contin-uing to match toward the center of thesignal distribution. The value to beingthe gerrymanderer increases with theextremity of voter preferences, the qual-ity of the signal, and the number of dis-tricts.

Sokoloff and Zolt turn to history togain a better perspective on how andwhy tax systems vary. They focus on thesocieties of the Americas over the nine-teenth and twentieth centuries, for twomajor reasons. First, despite the regionhaving the most extreme inequality in theworld, the tax structures of LatinAmerica are generally recognized asamong the most regressive, even bydeveloping country standards. Second, ashas come to be widely appreciated, the

The NBER’s Working Group onPolitical Economy, directed by NBERResearch Associate Alberto F. Alesinaof Harvard University, met inCambridge on November 19. The fol-lowing papers were discussed:

Timothy Besley, London School ofEconomics; Torsten Persson, Stock-holm University and NBER; andDaniel Sturm, University of Munich,“Political Competition and EconomicPerformance: Theory and Evidencefrom the United States”Discussant: Roberto Perotti, UniversitaBocconi and NBER

Allan Drazen, University of Marylandand NBER, and Marcela Eslava,Universidad de los Andes, “Pork BarrelCycles”Discussant: Alessandro Lizzeri, NewYork University

John N. Friedman and Richard T.Holden, Harvard University, “OptimalGerrymandering”Discussant: Roland G. Fryer, HarvardUniversity

Kenneth L. Sokoloff, UC, LosAngeles and NBER, and Eric M. Zolt,

UC, Los Angeles, “Inequality and theEvolution of Institutions of Taxation:Evidence from the Economic Historyof the Americas”Discussant: William Easterly, NewYork University

Per Pettersson-Lidbom, StockholmUniversity, and Matz Dahlberg,Uppsala University, “An EmpiricalApproach for Estimating the CausalEffect of Soft Budget Constraints onEconomic Outcomes”Discussant: Antonio Merlo, Universityof Pennsylvania

Political Economy


colonization and development of theAmericas constitute a natural experimentof sorts that students of economic andsocial development can exploit.Beginning more than 500 years ago, asmall number of European countriesestablished colonies in diverse environ-ments across the hemisphere. The differ-ent circumstances meant that largelyexogenous differences existed acrossthese societies, not only in national her-itage, but also in the extent of inequality.The principal concern in this paper iswith how the extent of inequality mayinfluence the design and implementationof tax systems. Several salient patternsemerge. The United States and Canada(like Britain, France, Germany, and evenSpain) were much more inclined to taxwealth and income during their earlystages of growth — and into the twenti-eth century — than developing countriesare today. Although the U.S. andCanadian federal governments were sim-ilar to those of their counterparts inLatin America in relying primarily on thetaxation of foreign trade (overwhelming-ly tariffs) and excise taxes, the greatersuccess or inclination of state (provin-cial) and local governments in NorthAmerica to tax wealth (primarily in theform of property or estate taxes) andincome (primarily in the form of busi-ness taxes), as well as the much larger rel-ative sizes of these sub-national govern-

ments in North America, accounted fora radical divergence in the overall struc-ture of taxation. Tapping these progres-sive sources of government revenue,state and local governments in theUnited States and Canada, even beforeindependence, began directing substan-tial resources toward public schools,improvements in infrastructure involv-ing transportation and health, and othersocial programs. In contrast, the societiesof Latin America, which had come to becharacterized soon after initial settlementby rather extreme inequality in wealth,human capital, and political influence,tended to adopt tax structures that weresignificantly less progressive in incidenceand manifested greater reluctance orinability to impose local taxes to fundlocal public investments and services.These patterns persisted, moreover, wellinto the twentieth century – indeed up tothe present day. The apparent associationbetween initial inequality and the institu-tions of taxation and public finance is allthe more intriguing in that Sokoloff andZolt find corresponding patterns acrossdifferent regions of the United Statesand across different countries of LatinAmerica.

Pettersson-Lidbom and Dahlbergdevelop an empirical framework for esti-mating the causal effect of soft budgetconstraints on economic outcomes.Their point of departure is that the

problem of the soft budget constraint isa problem of credibility; that is, inabilityof a supporting organization to commititself not to extend more resources to abudget-constrained organization (inother words, bailouts) ex post than it wasprepared to provide ex ante. This meansthat current economic behavior of abudget-constrained organization willdepend upon its expectations of beingbailed out in the future. Thus, to estimatethe causal effect of soft budget con-straints (that is, bailout expectations) oneconomic outcomes, one has to measurethese expectations and link them to thecurrent behavior of the budget-con-strained organization. The authors arguethat one can use information about real-ized bailouts to construct credible meas-ures of bailout expectations. They applyan empirical framework to Swedish localgovernments, which provide an attrac-tive testing ground for the soft budgetconstraint since the central governmenthas extended a total of 1,697 bailoutsover the period 1974 to 1992. Theauthors find that bailout expectationshave a causal effect on economic behav-ior. The estimated effect is quite sizeable:on average, a local government increasesits debt by 30 percent if it is certain ofbeing bailed versus when it is certain ofnot being bailed out.


Eckel and Neary present a newmodel of multi-product firms (MPFs)and flexible manufacturing and exploreits implications in partial and generalequilibrium. International trade integra-tion affects the scale and scope ofMPFs through a competition effect anda demand effect. The authors demon-strate how MPFs adjust in the presenceof single-product firms and in hetero-geneous industries. Their results are inline with recent empirical evidence andsuggest that MPFs in conjunction withflexible manufacturing play an impor-tant role in the impact of internationaltrade on product diversity – that is, therange of products produced by allfirms.

Nocke and Yeaple develop a theo-ry of multi-product firms that differ intheir organizational capabilities. In themodel, a firm’s unit cost is the endoge-nous outcome of its choice of the

number of its product lines. The moreproduct lines a firm manages, the high-er are its unit costs, but this trade-off isless severe for firms with greater orga-nizational capabilities. Paradoxically,more efficient firms optimally increasetheir scope to such an extent that theirunit costs are higher than those of lessefficient firms. The model thus explainsthe empirical puzzle that there is a neg-ative relationship between firm size andTobin’s Q. Positive industry shocks —such as those caused by trade liberaliza-tion — induce a merger wave that altersthe intra-industry dispersion ofobserved productivity as high-Q firmsbuy or sell product lines with low-Qfirms.

How are foreign direct investment(FDI) flows and patterns of multina-tional firm (MNC) activity determinedin a world with frictions in financialcontracting and variations in institution-

al environments? As developers oftechnologies, MNCs have long beencharacterized as having comparativeadvantage in monitoring the deploy-ment of their technology. Antras,Desai, and Foley show that, in a settingof non-contractible monitoring andfinancial frictions, this comparativeadvantage endogenously gives rise toMNC activity and FDI flows. Themechanism generating MNC activity isnot the risk of technological expropria-tion by local partners but the demandsof external funders who require MNCparticipation to ensure value maximiza-tion by local entrepreneurs. The modeldelivers distinctive predictions for theimpact of weak institutions on patternsof MNC activity and FDI flows, withweak institutional environments limit-ing the scale of multinational firm activ-ity but increasing the share of thatactivity that is financed by multinational

The NBER’s Program onInternational Trade and Investmentmet at the Bureau’s California officeon December 2 and 3. ProgramDirector Robert C. Feenstra ofUniversity of California, Davis,organized the meeting. The followingpapers were discussed:

Carsten Eckel, University ofGoettingen, and J. Peter Neary,University College Dublin, “Multi-Product Firms and FlexibleManufacturing in the GlobalEconomy”

Volker Nocke, University ofPennsylvania, and Stephen Yeaple,University of Pennsylvania andNBER, “Endogenizing Firm Scope:Multiproduct Firms in InternationalTrade”

Pol Antras, Mihir A. Desai, and C.Fritz Foley, Harvard University andNBER, “FDI Flows and Multi-national Firm Activity”

Lee J. Branstetter and RaymondFisman, Columbia University andNBER; C. Fritz Foley; and KamalSaggi, Southern Methodist Univer-sity, “Intellectual Property Rights,Imitation, and Foreign DirectInvestment: Theory and Evidence”

Andrew B. Bernard, DartmouthCollege and NBER; J. BradfordJensen, Institute for InternationalEconomics; and Peter Schott, YaleUniversity and NBER, “TransferPricing by U.S.-Based MultinationalFirms”

Diego Puga and Daniel Trefler,University of Toronto and NBER,“Wake Up and Smell the Ginseng:The Rise of Incremental Innovationin Low-Wage Countries”

Svetlana Demidova, PennsylvaniaState University; Hiau Looi Kee, TheWorld Bank; and Kala Krishna,Pennsylvania State University andNBER, “Rules of Origin and FirmHeterogeneity”

Christian Broda, University ofChicago; Nuno Limão, University ofMaryland; and David E. Weinstein,Columbia University and NBER,“Optimal Tariffs: The Evidence”

International Trade and Investment


parents through FDI flows. In additionto accounting for distinctions betweenpatterns of MNC activity and FDIflows, the model can help explain sub-stantial two-way FDI flows betweencountries with high levels of financialdevelopment and small and unbalancedFDI flows between countries with dif-ferent levels of financial development.The main predictions of the model aretested and confirmed using firm-leveldata on U.S. outbound FDI.

Does the adoption of strongerintellectual property rights (IPR) indeveloping countries enhance or retardtheir industrial development? How doessuch a policy shift affect industrial activ-ity in the developed countries, wheremost innovative activity is concentrat-ed? Branstetter, Fisman, Foley, andSaggi address these questions both the-oretically and empirically. On the theo-retical side, they develop a North-Southproduct cycle model in which Northerninnovation, Southern imitation, andFDI are all endogenous. This modelpredicts that IPR reform in the Southleads to increased FDI from the North,as Northern firms shift production toSouthern affiliates. This increased FDIdrives an acceleration of Southernindustrial development, as the South’sshare of global manufacturing and thepace at which production of morerecently invented goods shifts to theSouth both increase. The model alsopredicts that as production shifts to theSouth, Northern resources will be real-located to R and D, driving an increasein the global rate of innovation. Theauthors confront the theoretical modelwith evidence on the response of U.S.multinationals to a series of well-docu-mented IPR reforms by developingcountries in the 1980s and 1990s. Theirresults indicate that U.S.-based MNCsexpand the scale of their activities inreforming countries after IPR reform,and this effect is disproportionatelystrong for affiliates whose parents rely

strongly on patented intellectual prop-erty as part of their global businessstrategy. Data tracking industry levelvalue-added in the reforming countriespoint to an overall expansion of indus-trial activity after IPR reform. Finally,evidence from highly disaggregatedtrade data also suggests that the expan-sion of multinational activity leads to ahigher net level of production shiftingto developing countries, more than off-setting any possible decline in the imita-tive activity of indigenous firms.

Bernard, Jensen, and Schottexamine how prices set by multination-al firms vary across arm’s-length andrelated-party customers. They find thatarm’s length prices are substantially andsignificantly higher than related partyprices for U.S.-based multinationalexporters. The price difference is largeeven when comparing the export of thesame good by the same firm to thesame destination country in the samemonth by the same mode of transport.The price wedge is smaller for com-modities than for differentiated goodsand is increasing in firm size and firmexport share. The difference betweenarm’s length and related party prices isalso significantly greater for goods sentto countries with lower taxes and high-er tariffs. Changes in exchange rateshave differential effects on arm’s lengthand related party prices; an appreciationof the dollar strongly reduces the dif-ference between the prices

Increasingly, a small number oflow-wage countries such as China andIndia are involved in innovation — not“big ideas” innovation, but the constantincremental innovations needed to stayahead in business. Puga and Treflerprovide some evidence of this new phe-nomenon and develop a model in whichthere is a transition from old-style prod-uct-cycle trade to trade involving incre-mental innovation in low-wage coun-tries. They explain why levels ofinvolvement in innovation vary across

low-wage countries and even acrossfirms within each low-wage country.They then draw out implications for thelocation of production, trade, capitalflows, earnings and living standards.

Demidova, Kee, and Krishnadevelop a heterogeneous firm model tostudy the effects of trade policy, tradepreferences, and the rules of origin(ROOs) needed to obtain them. Theyapply their model to Bangladeshi gar-ment exports to the United States andEuropean Union. There are differencesacross products and export destinationsthat make for an interesting naturalexperiment. These differences generatedifferences in the composition ofexporters and productivity. The authorsuse data on Bangladeshi garmentexporters to construct firm-level totalfactor productivity (TFP) estimates.They then test the predictions of themodel on the relationship between thedistributions of TFP of various groupsof firms. They show that the factsmatch the predictions of the model.

The theoretical debate overwhether countries can and should settariffs in response to export elasticitiesgoes back over a century to the writingsof Edgeworth (1894) and Bickerdike(1907). Despite the optimal tariff argu-ment’s centrality in debates over com-mercial policy, there exists no evidenceabout whether countries actually use itin setting tariffs. Broda, Limão, andWeinstein estimate disaggregate exportelasticities and find that countries thatare not members of the World TradeOrganization systematically set highertariffs on goods that are supplied inelas-tically. The result is robust to the inclu-sion of political economy variables anda variety of model specifications.Moreover, they find that countries withhigher aggregate market power have onhigher average tariffs. In short, there isstrong evidence in favor of the optimaltariff argument.


Acemoglu and Finkelstein exam-ine the implications of regulatorychange for the input mix and technolo-gy choices of regulated industries. Theypresent a simple neoclassical frameworkthat emphasizes changes in relative fac-tor prices faced by regulated firmsunder different regimes, and investigatehow this might affect technology choic-es through substitution of (capitalembodied) technologies for tasks previ-ously performed by labor. They empiri-cally examine some of the implicationsof the framework by studying thechange from full cost to partial costreimbursement under the MedicareProspective Payment System (PPS)reform, which increased the relativeprice of labor faced by U.S. hospitals.Using the interaction of hospitals’ pre-PPS Medicare share of patient dayswith the introduction of these regulato-ry changes, they document a substantialincrease in capital-labor ratios and alarge decline in labor inputs associated

with PPS. Most interestingly, they findthat the PPS reform seems to haveencouraged the adoption of a range ofnew medical technologies. They alsoshow that the reform was associatedwith an increase in the skill compositionof these hospitals, which is consistentwith technology-skill or capital-skillcomplementarities.

Azoulay and Zivin estimate themagnitude of knowledge spillovers gen-erated by 4,764 academic superstars inthe life sciences onto their coauthors’research productivity. Using matchedemployee-employer data, the authorsmeasure how scientic output (grants,publications, and patents) for a coau-thor changes when the superstar movesto or from a different institution.Preliminary results indicate that super-stars generate substantial spilloversthrough two independent channels:location and co-authorship. Locationspillovers decline more than linearlywith geographic distance. Substitution

away from collaboration with other sci-entists cancels a significant portion ofthe benefits of exposure to superstartalent. The authors also find that thelocation spillovers declined markedly inthe 1990s.

Wu, Popp, and Bretschneiderexamine the effect of three majornational innovation policies (patent pro-tection, R and D tax incentives, andgovernment funding of business R andD) on business R and D spending.Unlike previous work, their study con-siders the effect of openness to interna-tional trade. They use data from nineOECD countries (Australia, Canada,France, Germany, Italy, Japan, Spain,United Kingdom, and United States) in1985–95. Their results show that allthree innovation policies play a signifi-cant role in stimulating business fundedand performed R and D. Among thecomponents of patent rights, enforce-ment of patent legal regime and dura-tion of protection term consistently

The NBER’s Program onProductivity met in Cambridge onDecember 2. Program Director ErnstR. Berndt of MIT and Pierre Azoulay,NBER and Columbia University,organized the meeting. The agendawas:

Amy Finkelstein and DaronAcemoglu, MIT and NBER, “Inputand Technology Choices in RegulatedIndustries: Evidence from the HealthCare Sector”Discussant: David M. Cutler, HarvardUniversity and NBER

Pierre Azoulay, and Joshua GraffZivin, Columbia University andNBER, “Peer Effects in the Workplace:

Evidence from Professional Tran-sitions for the Superstars of Medicine”Discussant: Manuel Trajtenberg, TelAviv University and NBER

Laura Schultz and Sumiye Okubo,Bureau of Economic Analysis —Report on the BEA/NSF R and DSatellite Accounts: Estimating theReturns and Spillovers from Business Rand D

Yonghong Wu, University of Illinois;David Popp, Syracuse University andNBER; and Stuart Bretschneider,Syracuse University, “The Effects ofInnovation Policies on Business R&D:A Cross-National Empirical Study”

Discussant: Margaret Kyle, DukeUniversity and NBER

Nick Bloom, Stanford University, andJohn Van Reenan, London School ofEconomics, “Measuring and Explain-ing Management Practices AcrossFirms and Countries”Discussant: Richard B. Freeman,Harvard University and NBER

James D. Adams, RenssalaerPolytechnic University and NBER, andJ. Roger Clemmons, University ofFlorida, “Industrial Scientific Discov-ery”Discussant: Scott Stern, NorthwesternUniversity and NBER

Productivity Program Meeting


have a positive effect on business R andD decisions. In addition, R and D per-formed by the government has a posi-tive effect on business R and D, while Rand D by the higher education sectorhas a negative impact on business R andD. The authors also find modest empir-ical support for the positive role ofopenness to international trade in busi-ness R and D investment.

Bloom and Reenen use an innova-tive survey tool to collect managementpractice data from 732 medium-sizedmanufacturing firms in the UnitedStates, France, Germany, and theUnited Kingdom. These measures ofmanagerial practice are strongly associ-ated with productivity, profitability,Tobin’s Q, sales growth, and survivalrates. Management practices also dis-play significant cross-country differ-ences, with U.S. firms on average bettermanaged than European firms, and sig-nificant within-country differences witha long tail of extremely badly managedfirms. The authors find this is attributa-ble to: different levels of product mar-ket competition, associated with bettermanagement; and family firms passingmanagement control down to the eldestsons (primo geniture), associated withworse management. European firmsreport lower levels of competition,

while French and British firms alsoreport substantially higher levels ofprimo geniture because of the influence ofNorman legal origin. These two factorsexplain up to two thirds of the averageU.S.-Europe management gap.

Adams and Clemmons estimatescience production functions for top Rand D firms in the United States. Theirdata include estimated flows of basicscience from universities to firms, fromfirms to other firms, and within firms.The underlying evidence consists ofpapers and citations from the Institutefor Scientific Information (ISI) inPhiladelphia, Pennsylvania. The datacover the top 200 R and D firms andthe top 110 universities during 1981–99.These account for most U.S. scientificresearch during this period. Theirempirical estimates are based on a panelof firms, science fields, and years that isan extract from the papers and citationsdata. Using this panel, they find that sci-ence spillovers from universities andother firms occur primarily withinfields. Industry is much less of a barrierand, in fact, most knowledge flowsoccur between, rather than withinindustries. Citation and collaborationspillovers from universities, citationspillovers from other firms, and citationspillbacks from firms’ past research all

make significant contributions to scien-tific discovery. The authors also uncov-er a host of potential biases. First, theresponse of discovery to the firms’ ownR and D is biased upward by the failureto include science spillovers from uni-versities and other firms. Second, theuniversity citation spillover is biasedupward by the failure to include collab-oration between firms and universities.Third, the effects of spillovers and spill-backs are biased downward whenzeroes of the spillovers and spillbacksare not considered by the estimationprocedure. The elasticity of firms’ sci-ence output with respect to universitycitation spillovers is consistently largerthan the firm spillover elasticity. Inaddition, the marginal product of uni-versity spillovers exceeds the marginalproduct of firm spillovers, so that addi-tional science output per dollar of uni-versity R and D is several times largerthan additional output per dollar offirm R and D. University collaborationonly serves to increase this productivityadvantage of universities. Since univer-sity R and D is primarily funded by gov-ernment, this potency of universityspillovers appears to reassert the role ofpublicly funded science in propagatingknowledge externalities throughout theU.S. economy.


Corruption and Reform: Lessons fromAmerica’s Economic History, edited byEdward L.Glaeser and Claudia Goldin,is available from the University ofChicago Press. This NBER ConferenceReport may be purchased for $75.00from: University of Chicago Press,Order Department, 11030 SouthLangley Avenue, Chicago, IL 60628-2215; 1-800-621-2736. Academic dis-counts are available.

Despite recent corporate scandals,the United States is among the world’sleast corrupt nations. But in the nine-teenth century, municipal governmentsand robber barons alike found newways to steal from taxpayers and swin-dle investors. In Corruption and Reform,

contributors explore this shadowy peri-od of U. S. history in search of bettermethods of fighting corruption world-wide today.

The chapters in this volume addressthe measurement and consequences offraud and corruption and the forcesthat ultimately led to their decline with-in the United States. They show thatvarious approaches to reducing corrup-tion, such as deregulation and in partic-ular “free banking” in the 1830s, havemet with success. In the 1930s, corrup-tion was kept in check when new feder-al bureaucracies replaced local adminis-trations in doling out relief. Anotherdeterrent to corruption was the inde-pendent press, which kept a watchful

eye over government and business.These and other facets of Americanhistory analyzed in this volume make itindispensable as background for anyoneinterested in corruption today.

Glaeser is a Research Associate inthe NBER’s Programs on Aging, Lawand Economics, and EconomicFluctuations and Growth. He is also theFred and Eleanor Glimp Professor ofEconomics at Harvard’s KennedySchool of Government.

Goldin directs the NBER’sProgram on the Development of theAmerican Economy and is the HenryLee Professor of Economics atHarvard.

Bureau Books

Corruption and Reform: Lessons from America’s Economic History

The Democratization of Invention:Patents and Copyrights in AmericanEconomic Development, 1790-1920, by B.Zorina Khan, is available fromCambridge University Press for $60.00.

An examination of the evolutionand impact of American intellectualproperty rights during the “long nine-teenth century,” this monograph com-pares the American system to that ofthe more oligarchic societies of Franceand Britain. The United States createdthe first modern patent system and itspolicies toward inventors were themost liberal in the world. Individualswho did not have the resources todirectly exploit their inventions benefit-ed disproportionately from secure

property rights and the operation ofefficient markets. When marketsexpanded, these inventors contributedto the proliferation of new technolo-gies and improvements. In contrast toits leadership in the area of patents, theU.S. copyright regime was among theweakest in the world, in keeping with itsutilitarian objective of promoting thegeneral welfare. American patent andcopyright institutions promoted aprocess of democratization that notonly furthered economic and techno-logical progress but also provided aconduit for the creativity and achieve-ments of disadvantaged groups.

The topics discussed in this book,part of the NBER’s series on Long-

Term Factors in EconomicDevelopment, include: patent laws andlitigation; women inventors in America;patentees and married women’s proper-ty rights; and intellectual property andeconomic development.

Khan is a Faculty Research Fellowin the NBER’s Program on theDevelopment of the AmericanEconomy and a member of the eco-nomics faculty at Bowdoin College.

Orders for the book should be sentto the Press at: 100 Brook HillDrive,West Nyack, NY 10994-2133.Or, by phone: 800-872-7423 (U.S. andCanada); 95-800-010-0200 (Mexico); or845-353-7500.

The Democratization of Invention: Patents and Copyrights inAmerican Economic Development, 1790-1920


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Current Working Papers

NBER Working Papers

11752 Yongmin Chen Buyer Investment, Product Variety, and Intrafirm TradeRobert C. Feenstra

11753 Benjamin A. Olken Monitoring Corruption: Evidence from a FieldExperiment in Indonesia

11754 Trevon D. Logan The Transformation of Hunger: The Demand forCalories Past and Present

11755 Xavier Gabaix Shrouded Attributes, Consumer Myopia, andDavid Laibson Information Suppression in Competitive Markets

11756 Clemens Sialm Tax Changes and Asset Pricing: Time-Series Evidence

11757 Itay Goldstein An Information-Based Trade Off between ForeignAssaf Razin Direct Investment and Foreign Portfolio Investment

11758 Bruce N. Lehmann The Role of Beliefs in Inference for RationalExpectations Models


11759 John F. Helliwell How’s the Job? Well-Being and Social CapitalHaifang Huang in the Workplace

11760 Raj Chetty Why do Unemployment Benefits Raise Unemployment Durations? The Role of Borrowing Constraints andIncome Effects

11761 Menzie D. Chinn Current Account Balances, Financial Development,Hiro Ito and Institutions: Assaying the World “Savings Glut”

11762 Andrew K. Rose Cities and Countries

11763 Li Gan A Simple Test of Adverse Events and StrategicTarun Sabarwal Timing Theories of Consumer Bankruptcy

11764 Fernando Alvarez General Equilibrium Analysis of the Eaton-KortumRobert E. Lucas Model of International Trade

11765 Benjamin Edelman Internet Advertising and the Generalized SecondMichael Ostrovsky Price Auction: Selling Billions of Dollars Worth of KeywordsMichael Schwarz

11766 Marcin Kacperczyk Unobserved Actions of Mutual FundsClemens SialmLu Zheng

11767 Wojciech Kopczuk To Leave or Not To Leave: The Distribution ofJoseph P. Lupton Bequest Motives

11768 Wojciech Kopczuk Electronic Filing, Tax Preparers, and ParticipationCristian Pop-Eleches in the Earned Income Tax Credit

11769 Kathryn Dominguez What Defines “News” in Foreign Exchange Markets?Freyan Panthaki

11770 Toshiaki Iizuka Drug Advertising and Health HabitsGinger Zhe Jin

11771 Michael P. Dooley Interest Rates, Exchange Rates, andDavid Folkerts-Landau International AdjustmentPeter M. Garber

11772 Joseph E. Stiglitz The Creation of the Rule of Law and theKarla Hoff Legitimacy of Property: The Political and

Economic Consequences of a Corrupt Privatization



11773 Ann P. Bartel How Does Information Technology ReallyCasey Ichniowski Affect Productivity? Plant-Level Comparisons ofKathryn L. Shaw Product Innovation, Process Improvement, and Worker Skills

11774 Bee Yan Aw The Complementary Role of Exports and R&DMark J. Roberts Investments as Sources of Productivity GrowthTor Winston

11775 Torben G. Anderson Roughing it Up: Including Jump ComponentsTim Bollerslev in the Measurement, Modeling, and ForecastingFrancis X. Diebold of Return Volatility

11776 Robert J. Gordon A Century of Housing Shelter Prices: Is thereTodd vanGoethem a Downfall Bias in the CPI?

11777 Robert J. Gordon What Caused the Decline in U.S.Business Cycle Volatility?

11778 Robert J. Gordon The 1920s and the 1990s in Mutual Reflection

11779 Roberto Chang Financial Crises and Political Crises

11780 A. Mitchell Polinsky The Theory of Public Law EnforcementSteven Shavell

11781 Steven Shavell Liability for Accidents

11782 David Neumark The Effects of Wal-Mart on Local Labor MarketsJunfu ZhangStephen Ciccarella

11783 Farley Grubb The U.S. Constitution and Monetary Powers

11784 Farley Grubb Two Theories of Money Reconciled: The ColonialPuzzle Revisited with New Evidence

11785 Assaf Razin Evaluation of Currency Regimes: The Unique RoleYona Rubinstein of Sudden Stops

11786 Gary Charness Pay Inequality, Pay Secrecy, and Effort:Peter Kuhn Theory and Evidence

11787 Roberto Chang Openness Can be Good for Growth:Linda Kaltani The Role of Policy ComplementaritiesNorman Loayza



11788 Jordi Gali Robustness of the Estimates of theMark Gertler Hybrid New Keynesian Phillips CurveJ. David Lopez-Salido

11789 Edward L. Glaeser Paternalism and Psychology

11790 Michael Greenstone Does Hazardous Waste Matter? EvidenceJustin Gallagher from the Housing Market and the Superfund Program

11791 Amartya Lahiri Output Costs, Currency Crises, and theCarlos A. Vegh Interest Rate Defense of a Peg

11792 Linda S. Goldberg Establishing Credibility: Evolving PerceptionsMichael W. Klein of the European Central Bank

11793 David G. Blanchflower An Analysis of the Impact of Affirmative ActionJon Wainwright Programs on Self-Employment in the Construction Industry

11794 Justine S. Hastings Economic Outcomes and the Decision to Vote:Thomas J. Kane The Effect of Randomized School AdmissionDouglas O. Staiger on Voter ParticipationJeffrey M. Weinstein

11795 Natalia Chernyshoff Stuck on Gold: Real Exchange Rate VolatilityDavid S. Jacks and the Rise and Fall of the Gold StandardAlan M. Taylor

11796 Sandra E. Black From the Cradle to the Labor Market? Paul J. Devereux The Effect of Birth Weight on Adult OutcomesKjell Salvanes

11797 Woojin Kim Motivations for Public Equity Offers:Michael S. Weisbach An International Perspective

11798 Bruce A. Blonigen Foreign Subsidization and the ExcessWesley W. Wilson Capacity Hypothesis

11799 Bruce A. Weinberg Creative Careers: The Life Cycles ofDavid W. Galenson Nobel Laureates in Economics

11800 Dale W. Jorgenson The Industry Origins of Japanese Economic GrowthKoji Nomura

11801 Dale W. Jorgenson Information Technology and the Japanese EconomyKazuyuki Motohashi



11802 Patrick Bayer Choice and Competition in Local Education MarketsRobert McMillan

11803 Bernard Dumas What Can Rational Investors Do About ExcessiveAlaxender Kurshev Volatility and Sentiment Fluctuations?Raman Uppal

11804 Irene Brambilla Farm Productivity and Market Structure:Guido Porto Evidence from Cotton Reforms in Zambia

11805 Justine S. Hastings Parental Preferences and School Competition:Thomas J. Kane Evidence from a Public School Choice ProgramDouglas O. Staiger

11806 Olivier Blanchard Real Wage Rigidities and the New Keynesian ModelJordi Gali

11807 John F. Helliwell Well-Being, Social Capital, and Public Policy:What’s New?

11808 Leora Friedberg Searching for Better Prospects: EndogenizingMichael T. Owyang Failing Job Tenure and Private Pension CoverageTara M. Sinclair

11809 Jerry Hausman Consumer Benefits from Increased Competition inEphraim Leibtag Shopping Outlets: Measuring the Effect of Wal-Mart

11810 Thomas J. Philipson Who Benefits from New Medical Technologies?Anupam B. Jena Estimates of Consumer and Prodicer Surpluses for

HIV/AIDS Drugs

11811 Mark Duggan Aching to Retire? The Rise in the Full Retirement Age Perry Singleton and its Impact on the Disability RollsJae Song

11812 Susanna Loeb How Much is Too Much? The Influence of Preschool Margaret Bridges Centers on Children’s Social and Cognitive DevelopmentDaphna BassokBruce FullerRuss Rumberger

11813 Patrick Bayer Racial Sorting and Neighborhood QualityRobert McMillan

11814 Frederic S. Mishkin How Big a Problem is Too Big to Fail?



11815 Jordi Gali Optimal Monetary and Fiscal Policy in a Currency UnionTommaso Monacelli

11816 Tano Santos Cash-Flow Risk, Discount Risk, and the Value PremiumPietro Veronesi

11817 Paul Oyer Salary or Benefits?

11818 Dana Goldman Medical Expenditure Risk andNicole Maestas Household Portfolio Choice

11819 Katherine Ho The Welfare Effects of Restricted HospitalChoice in the US Medical Care Market

11820 Ricardo Reis Inattentive Producers

11821 Paul R. Bergin Towards a Theory of Firm Entry and Stabilization PolicyGiancarlo Corsetti

11822 Katherine Ho Insurer-Provider Networks in the Medical Care Market

11823 Caroline Freund Current Account Deficits in Industrial Countries:Frank Warnock The Bigger they are the Harder they Fall?

11824 Andrew Ang Downside RiskJoseph ChenYuhang Xing

11825 Dora L. Costa Surviving Andersonville: The Benefits ofMatthew E. Kahn Social Networks in POW Camps

11826 George-Marios Angeletos Efficiency and Welfare with ComplementaritiesAlessandro Pavan and Asymmetric Information

11827 James Markusen Modeling the Offshoring of White-Collar Services:From Comparative Advantage to the New Theories of Tradeand FDI

11828 David Hummels Trade in Ideal Varieties: Theory and EvidenceVolodymyr Lugovskyy

11829 David Card The Effect of Firm-Level Contracts on the StructureSara de la Rica of Wages: Evidence from Matched Employer-Employee Data

11830 Stephen G. Cecchetti Do Capital Adequacy RequirementsLianfi Li Matter for Monetary Policy?



11831 Laurence J. Kotlikoff Would the FairTax Raise or Lower MarginalDavid Rapson and Average Tax Rates

11832 Michael Baker Universal Childcare, Maternal Labor Supply, andJonathan Gruber Family Well-BeingKevin Milligan

11833 Laurence J. Kotlikoff Who’s Going Broke? Comparing Growth in HealthcareChristian Hagist Costs in Ten OECD Countries

11834 Ricardo J. Caballero Financial System Risk and Flight to QualityArvind Krishnamurthy

11835 Joshua D. Angrist New Evidence on the Causal Link Between theVictor Lavy Quantity and Quality of ChildrenAnalia Schlosser

11836 Chulhee Lee Rising Family Income Inequality in the United States,1968-2000: Impacts of Changing Labor Supply, Wages,and Family Structure

11837 Dan T. Rosenbaum The Cost of Caring for Young ChildrenChristopher J. Ruhm

11838 Sendhil Mullainathan Persuasion in FinanceAndrei Shleifer

11839 Esteban Rossi-Hansberg Firm Fragmentation and Urban PatternsPierre-Daniel SarteRaymond Owens III

11840 Jacob Boudoukh The Information in Long-Maturity Forward Rates:Matthew Richardson Implications for Exchange Rates and the ForwardRobert Whitelaw Premium Anomaly

11841 Jacob Boudoukh The Myth of Long-Horizon PredictabilityMatthew RichardsonRobert Whitelaw

11842 Ian Dew-Becker Where did the Productivity Growth Go? InflationRobert J. Gordon Dynamics and the Distribution of Income

11843 Nicolae Garleanu Demand-Based Option PricingLasse Heje PedersenAllen M. Poteshman



11844 Donald Boyd How Changes in Entry Requirements Alter the Pamela Grossman Teacher Workforce and Affect Student AchievementHamilton LankfordSusanna LoebJames Wyckoff

11845 Daron Acemoglu Equilibrium Bias of Technology

11846 Richard J. Murnane Improving the Performance of the Education Sector:Richard R. Nelson The Valuable, Challenging, and Limited Role of

Random Assignment Evaluations

11847 Jeffrey R. Campbell Competition in Large Markets

11848 Charles F. Manski Search Profiling with Partial Knowledge of Deterrence

11849 Rebecca Henderson Inertia and Incentives: Bridging OrganizationalSarah Kaplan Economics and Organizational Theory

11850 Axel Boersch-Supan Aging, Pension Reform, and Capital Flows:Alexander Ludwig A Multi-Country Simulation ModelJoachim Winter

11851 Xavier Gabaix Limits of Arbitrage: Theory and Evidence from theArvind Krishnamurthy Mortgage-Backed Securities MarketOlivier Vigneron

11852 Annabelle Gawer Platform Owner Entry and Innovation inRebecca Henderson Complementary Markets: Evidence from Intel

11853 Menzie D. Chinn Three Current Account Balances:Jaewoo Lee A “Semi-Structuralist” Interpretation

11854 Stephanie Schmitt-Grohe Optimal Inflation Stabilization in aMartin Uribe Medium-Scale Macroeconomic Model

11855 David Neumark The Impact of Provider Choice on Workers’Peter S. Barth Compensation Costs and OutcomesRichard Victor

11856 Martin Feldstein Monetary Policy in a Changing International Environment:The Role of Capital Flows

11857 Edward L. Glaeser Myths and Realities of American Political Geography Bryce A. Ward



11858 Laurence J. Kotlikoff Simulating the Dynamic Macroeconomic andSabine Jokisch Microeconomic Effects of the FairTax

11859 Joni Hersch The Generational Divide in Support for Environmental W. Kip Viscusi Policies: European Evidence

11860 Edward J. Kane Can the European Community Afford to Neglect theNeed for More Accountable Safety-Net Management?

11861 Luca Benzoni Can Standard Preferences Explain the Prices ofPierre Collin-Dufresne Out-of-the-Money S&P 500 Put OptionsRobert S. Goldstein

11862 Adi Brender How Do Budget Deficits and Economic Growth Affect Allan Drazen Reelection Prospects? Evidence from a Large Cross-Section

of Countries

11863 W. Kip Viscusi The Perception and Valuation of the Risks ofRichard J. Zeckhauser Climate Change: A Rational and Behavioral Blend

11864 Jaime Casassus Equilibrium Commodity Prices with Irreversible Pierre-Collin Dufresne Investment and Non-Linear TechnologyBryan R. Routledge

11865 Edward J. Kane Confronting Divergent Interests in Cross-CountryRegulatory Arrangements

11866 Timothy J. Hatton A Dual Policy Paradox: Why Have Trade and Jeffrey G. Williamson Immigration Policies Always Differed in

Labor-Scarce Economies?

11867 Patrick Bolton Thinking Ahead: The Decision ProblemAntoine Faure-Grimaud

11868 Farley Grubb The Net Asset Position of the U.S. National Government,1784-1802: Hamilton’s Blessing or the Spoils of War?

11869 David B. Gordon Are Countercyclical Fiscal Policies Counterproductive?Eric M. Leeper

11870 Adam Copeland The Response of Prices, Sales, and OutputGeorge Hall to Temporary Changes in Demand

11871 Harsha Thirumurthy The Economic Impact of AIDS Treatment:Joshua Graff Zivin Labor Supply in Western KenyaMarkus Goldstein



11872 Lingxin Hao Games Parents and Adolescents Play: Risky Behaviors,V. Joseph Hotz Parental Reputation, and Strategic TransfersGinger Z. Jin

11873 V. Joseph Hotz The Impact of Minimum Quality Standards on Firm Entry,Mo Xiao Exit, and Product Quality: the Case of the Child Care Market

11874 Troy Davig Generalizing the Taylor PrincipleEric M. Leeper

11875 John A. Vernon The Future of Drug Development:W. Keener Hughen The Economics of Phamacogenomics

11876 Lubos Pastor Technological Revolution and Stock PricesPietro Veronesi

11877 Peter Diamond Pensions for an Aging Population

11878 Ann Huff Stevens The More Things Change, the More TheyStay the Same: Trends in Long-term Employment in theUnited States, 1969-2002

11879 Shin-Yi Chou Fast-Food Restaurant Advertising on TelevisionInas Rashad and its Influence on Childhood ObesityMichael Grossman

11880 Esther Duflo Monitoring Work: Getting Teachers to Come to SchoolRema Hanna

11881 Henry Saffer The Demand for Social Interaction

11882 Owen A. Lamont Investor Sentiment and Corporate Finance:Jeremy C. Stein Micro and Macro

11883 Simeon Djankov The Law and Economics of Self-DealingRafael La PortaFlorencio Lopez-de-SilanesAndrei Shleifer

11884 Kevin H. O’Rourke Did Vasco da Gama Matter for European Markets?Jeffrey G. Williamson Testing Frederick Lane’s Hypotheses Fifty Years Later

11885 Robert C. Feenstra Contractual Versus Generic Outsourcing:Barbara J. Spencer The Role of Proximity

11886 Lucian Bebchuk Firm Expansion and CEO PayYaniv Grinstein



11887 Amil Petrin Measuring Aggregate Productivity Growth UsingJames Levinsohn Plant-Level Data

11888 Robert Shimer Mismatch

11889 William D. Nordhaus Life After Kyoto: Alternative Approachesto Global Warming

11890 James E. Rauch Neckties in the Tropics: A Model of InternationalVitor Trindade Trade and Cultural Diversity

11891 Frederic S. Mishkin Is Financial Globalization Beneficial?

11892 Marianne Bertrand What’s Psychology Worth? A Field ExperimentDean Karlan in the Consumer Credit MarketSendhil MullainathanEldar ShafirJonathan Zinman

11893 Pinka Chatterji Psychiatric Disorders and Labor Market Outcomes:Margarita Alegria Evidence from the National Latino and Asian American StudyMingshan LuDavid Takeuchi

11894 Ross Levine Internationalization and Stock Market LiquiditySergio Schmukler

11895 Peter Kuhn The Expanding Workweek? Understanding TrendsFernando Lozano in Long Work Hours Among U.S. Men, 1979-2004

11896 Michael Woodford Robustly Optimal Monetary Policy withNear Rational Expectations

11897 Michael D. Bordo The Role of Foreign Currency Debt in Financial Crises:Christopher M. Meissner 1880-1913 vs. 1972-1997

11898 Michael Woodford Central Bank Communication and Policy Effectiveness

11899 David W. Galenson The Greatest Artists of the Twentieth Century

11900 Gabriel Weintraub Markov Perfect Industry Dynamics with Many FirmsC. Lanier BenkardBen Van Roy

11901 Laura Alfaro Why Doesn’t Capital Flow from Rich to Poor Countries?Sebnem Kalemli-Ozcan An Empirical InvestigationVadym Volosovych



11902 Philip J. Cook The Myth of the Drinker’s Bonus

11903 Andrew Ang CAPM Over the Long Run: 1926-2001

11904 Abhijit Banerjee Remedying Education: Evidence from Two Randomized Shawn Cole Experiments in IndiaEsther DufloLeigh Linden

11905 Ricardo Hausmann What You Export MattersJason HwangDani Rodrik

11906 Geert Bekaert International Stock Return ComovementsRobert J. HodrickXiaoyan Zhang

11907 Lucian A. Bebchuk Executive PensionsRobert J. Jackson

11908 Lee. J. Alston Who Should Govern Congress?Jeffrey A. Jenkins Access to Power and the Salary Grab of 1873Tomas Nonnenmacher

11909 Lisa Sanbonmatsu Neighborhoods and Academic Achievement:Jeffrey R. Kling Results from the Moving to Opportunity ExperimentGreg J. DuncanJeanne Brooks-Gunn

11910 Sendhil Mullainathan Sticking with Your Vote: Cognitive Dissonance and VotingEbonya Washington

11911 David Bell The Scots May be Brave but They are Neither Healthy David G. Blanchflower Nor Happy

11912 Rene M. Stulz Financial Globalization, Corporate Governance,and Eastern Europe

11913 Martin Uribe On Overborrowing

11914 A. Burak Guner The Impact of Boards with Financial ExpertiseUlrike Malmendier on Corporate PoliciesGeoffrey Tate

11915 Ebonya Washington How Black Candidates Affect Voter Turnout



11916 Orley Ashenfleter Measuring the Value of a Statistical Life: Problemsand Prospects

11917 Pierre Azoulay The Impact of Academic Patenting on the Rate, Quality,Waverly Ding and Direction of (Public) Research OutputToby Stuart

11918 David Card When to Start a Fight and When to Fight Back: LiabilityBrian P. McCall Disputes in the Workers Compensation System

11919 Sung Won Kang Capitalizing Patriotism: The Liberty Loans of World War IHugh Rockoff

11920 John Beshears Early Decisions: A Regulatory FrameworkJames J. ChoiDavid LaibsonBrigitte C. Madrian

11921 Charles Engel The U.S. Current Account Deficit and theJohn H. Rogers Expected Share of World Output

11922 Pierpaolo Benigno Overconfidence, Subjective Perception,Anastasios G. Karantounias and Pricing Behavior

11923 Lawrence H. Goulder The Economics of Climate ChangeWilliam A. Pizer

11924 Ebonya Washington Female Socialization: How Daughters AffectTheir Legislator Fathers’ Voting on Women’s Issues

11925 Andrew Leigh Happiness and the Human Development Index:Justin Wolfers Australia is Not a Paradox

11926 Mary Amiti Service Offshoring and Productivity:Shang-Jin Wei Evidence from the United States

11927 Zeynep Hansen The Political Economy of “Truth-in-Advertising”Marc T. Law Regulation During the Progressive Era

11928 Diego Comin Five Facts You Need to Know About Technology DiffusionBart HobijnEmilie Rovito

11929 Refet Gurkaynak Macroeconomic Derivatives: An Initial Analysis ofJustin Wolfers Market-Based Macro Forecasts, Uncertainty, and Risk



11930 Tomas Philipson IP & External Consumption Effects: GeneralizationsStephanie Mechoulan from Health Care MarketsAnupam B. Jena

11931 Jeremy Atack Steam Power, Establishment Size, and LaborFred Bateman Productivity Growth in Nineteenth CenturyRobert Margo American Manufacturing

11932 Peter Kuhn The Long-Term Effects of a Generous IncomeChris Riddell Support Program: Unemployment Insurance in

New Brunswick and Maine, 1940-1991

11933 Joshua Aizenman Globalization and Developing Countries —Yothin Jinjarek A Shrinking Tax Base?

11934 W. Kip Viscusi Regulation of Health, Safety, and Environmental Risks

11935 W. Kip Viscusi Hyperbolic Discounting of Public GoodsJoel Huber

11936 Charles T. Clotfelter Teacher-Student Matching and the Assessment ofHelen F. Ladd Teacher EffectivenessJacob L. Vigdor

11937 V. Joseph Hotz Strategic Information Disclosure: the Case ofMo Xiao Multi-Attribute Products with Heterogenous Consumers

11938 Rosemary Avery Private Profits and Public Health: Does AdvertisingDonald Kenkel Smoking Cessation Products Encourage Smokers to Quit?Dean R. DillardAlan Mathios

11939 V. Joseph Hotz Evaluating the Differential Effects of AlternativeGuido W. Imbens Welfare-to-Work Training Components: A Re-AnalysisJacob A. Klerman of the California GAIN Program


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Documents

NBER Reporter Winter 06NBER ReporterWinter 2005/6 1 Public Economics James M. Poterba* Researchers in the NBER Public Economics Program study many of the core issues that have been