The American Economic Review 1993: Vol 83 Table of Contents

365 Pages·1993·84.6 MB·English

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conomic Review.
ARTICLES
WILLIAM VICKREY _ Today’s Task for Economists
GIUSEPPE BERTOLA AND ALLAN DRAZEN
Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity
JOSEPH E. HARRINGTON, JR.
Economic Policy, Economic Performance, and Elections
A. ANDREW JOHN, ROWENA A. PECCH NO, AND STACEY L. SCHREFT
The Macroeconomics of Dr. Strangelove
NOBUHIRO KIYOTAKI AND RANDALL WRIGHT
A Search-Theoretic Approach to Monetary Economics
ANIL K KASHYAP, JEREMY C. STEIN, AND DAVID W. WILCOX
Monetary Policy and Credit Conditions: Evidence from the Composition
of External Finance
MICHELLE R. GARFINKEL AND SEONGHWAN OH
Strategic Discipline in Monetary Policy with Private Information:
Optimal Targeting Horizons
GREGORY K. DOW Why Capital Hires Labor: A Bargaining Perspective
IAN L. GALE AND THOMAS J. HOLMES
Advance-Purchase Discounts and Monopoly Allocation of Capacity
KALA KRISHNA Auctions with Endogenous Valuations: The Persistence of Monopoly
Revisited
RICHARD ARNOTT, ANDRE DE PALMA, AND ROBIN LINDSEY
A Structural Model of Peak-Period Congestion: A Traffic Bottleneck
with Elastic Demand
RICHARD H. CLARIDA
Entry, Dumping, and Shakeout
STEPHEN G. BRONARS AND DONALD R. DEERE
Union Organizing Activity, Firm Growth, and the Business Cycle
“HAEL R RANSOM
Seniority and Monopsony in the Academic Labor Market
SHORTER PAPERS: R. A. Margo and T. A. Fin i; M. Hionig and R. K. Filer; E. J. Dockner and
G. Feichtinger; G. D. Rudebusch; R. S. Pindyck; H. Bester; M. R. Baye, D. Kovenock, and C. G. de Vries;
X. Yang and B. J. Heijdra; A. K. Dixit and J. E. Stiglitz; J. Agell and B.-C. Ysander; S. Fischer and L. Summers.
MARCH 1993
THE AMERICAN ECONOMIC ASSOCIATION
Founded in 1885
Officers
President
ZVI GRILICHES
Harvard University
President-elect
AMARTYA SEN
Harvard University
Vice-Presidents
FRANCINE BLAU
University of Illinois
LESTER C. THUROW
Massachusetts Institute of Technology
Secretary-Treasurer
C. ELTON HINSHAW
Vanderbilt University
ePrinted at Banta Company, Menasha, Editor of The American Economic Review
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ORLEY C. ASHENFELTER
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THE AMERICAN ECONOMIC REVIEW
Editor March 1993
ORLEY ASHENFELTER
VOLUME 83, NUMBER I
Co-Editors
JOHN Y. CAMPBELL Articles
ROGER H. GORDON
Today’s Task for Economists William Vickrey
PAUL R. MILGROM
Trigger Points and Budget Cuts: Explaining the
Effects of Fiscal Austerity
Pro i i ;
duction Editor Giuseppe Bertola and Allan Drazen
J. DAVID BALDWIN
Economic Policy, Economic Performance, and
Boned of Bitters Elections Joseph E. Harrington, Jr.
JOSEPST G. -ALTONN The caer ep ere be Dr. ey gp As
Pee ee A. Andre“wOW John, Rowe) na A. Pecchenino,
wileiie Mileiiinas, and Staceeyy L. L. SSc hreft
ROBIN W. BOADWAY A Search-Theoretic Approach to Monetary Eco-
TIMOTHY F. BRESNAHAN nomics Nobuhiro Kiyotaki and Randall Wright
LORNE H. CARMICHAEL ee ee :
ernst G. CeccHETN Monetary Policy and Credit Conditions: Evi-
dence from the Composition of External Fi-
LAWRENCE J. CHRISTIANO
nance inil K Kashyap, Jeremy C. Stein,
GEORGE W. EVANS
and David W. Wilcox
MARJORIE A. FLAVIN
NANCY GALLINI Strategic Discipline in Monetary Policy with Pri-
JO ANNA GRAY vate Information: Optimal Targeting Horizons
DANIEL S. HAMERMESH Michelle R. Garfinkel and Seonghwan Oh
ROBERT H. HAVEMAN
Why Capital Hires Labor: A Bargaining Perspec-
ROBERT J. HODRICK
tive Gregory K. Dow
KEVIN D. HOOVER
R. MARK ISAAC Advance-Purchase Discounts and Monopoly
JOHN H. KAGEL Allocation of Capacity
JOHN F. RENNAN lan L. Gale and Thomas J. Holmes
R. PRESTON McAFEE
Auctions with Endogenous Valuations: The Per-
JOHN McMILLAN sistence of Monopoly Revisited Kala Krishna
JOHN ROBERTS
RICHARD ROLL A Structural Model of Peak-Period Congestion:
THOMAS ROMER A Traffic Bottleneck with Elastic Demand
icine i: italia Richard J. Arnott, Andre de Palma,
cesciniiidila testi and Robin Lindsey
HAL R. VARIAN Entry, Dumping, and Shakeout
KENNETH WEST Richard H. Clarida
JOHN D. WILSON _- a '
ge 5e e Union Organizing Activity, Firm Growth, and
the Business Cycle
Stephen G. Bronars and Donald R. Deere
Seniority and Monopsony in the Academic La-
bor Market Michael R Ransom
Shorter Papers
The Decline in Black Teenage Labor-Force Participation in the South, 1900-1970:
The Role of Schooling Robert A. Margo and T. Aldrich Finegan
Causes of Intercity Variation in Homelessness Marjorie Honig and Randall K. Filer
Cyclical Consumption Patterns and Rational Addiction
Engelbert J. Dockner and Gustav Feichtinger
The Uncertain Unit Root in Real GNP Glenn D. Rudebusch
A Note on Competitive Investment under Uncertainty Robert S. Pindyck
Bargaining versus Price Competition in Markets with Quality Uncertainty
Helmut Bester
Rigging the Lobbying Process: An Application of the All-Pay Auction
Michael R. Baye, Dan Kovenock, and Casper G. de Vries
Monopolistic Competition and Optimum Product Diversity
Comment Xiaokai Yang and Ben J. Heijdra
Reply Avinash K. Dixit and Joseph E. Stiglitz
Should Governments Learn to Live with Inflation?
Comment . Jonas Agell and Bengt-Christer Ysander
Reply Stanley Fischer and Lawrence Summers
Erratum
Government Size and Economic Growth: A New Framework and Some Evidence
from Cross-Section and Time-Series Data: Reply Rati Ram 314
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Number 94 of a series of photographs of past presidents of the Association

Today’s Task for Economists’
By WILLIAM VICKREY’
I. The Allocation Task of Yesteryear of regarding budget deficits as improvident
prodigality, and government debt as the
Nearly two score years ago, on the occa- legacy of a craven deferral of burden to the
sion of Columbia’s bicentennial celebration, future, resumed command.
Sir Dennis Robertson gave an address enti- One eminent economist is said to have
tled ““What Do Economists Economize,” the remarked, in effect, that it was the function
burden of which was that, since presumably of the science of public finance to see to it
economists are the most expert economiz- that nothing of importance is ever done or
ers, they should economize the most pre- left undone merely for financial reasons.
cious thing in the world, namely, love, or Alas, the financial reasons have thus far
altruism. This would be done in part by so carried the day, and we have not had any-
arranging things that in the ordinary con- thing approaching real full employment
duct of life individual choices made on the since the Korean War, or indeed in peace-
basis of self-interest in terms of market time at any time since 1925, if then, at least
prices would at least be consistent with max- in terms of the Beveridge definition of full
imizing social welfare, so that the exercise employment as a situation wherein there
of scarce resources of altruism could be are at least as many unfilled job openings as
concentrated on situations where Adam there are unemployed individuals seeking
Smith’s unseen hand could not be made to work.
serve. To me, one implication of this was In the Eisenhower years, the conven-
that economists should see to it that market tional wisdom held sway in spite of the
prices correctly reflect the relevant marginal absence of serious contraindications to the
social cost of various alternatives. I have Keynesian prescription. In the 1960’s, the
devoted a major part of my career to the simple Keynesian analysis began to be called
promotion of such marginal-cost pricing, but into question by the emergence of stagfla-
thus far with a notable lack of practical tion, a phenomenon not contemplated by
success outside academia. the earlier Keynesian models. A new rela-
At the time of Robertson’s address, in- tionship, the Phillips curve, relating the
deed, there was a certain euphoria prevail- evolution of inflation to the level of unem-
ing among at least part of the economics ployment was added to the economists’
profession over the prospect of curbing the armamentarium, with its “non-inflation-
business cycle and maintaining a high level accelerating rate of unemployment” or
of economic activity through Keynesian fis- NIARU.
cal policy. Under these circumstances it was This NIARU is of course not a fixed
reasonable to think that the chief remaining datum, but varies over time and place ac-
job of the economist was to assure a cording to the sociopolitical ambience, the
Pareto-efficient allocation of a given aggre- mechanics of the labor market, and the
gate of resources. The event, however, vigor of competition. It may have been ris-
proved otherwise. The conventional wisdom ing over time as a result of the increased
sophistication and differentiation of prod-
ucts, real and factitious, giving sellers, as
the ones most knowledgeable about the
‘Presidential address prepared for the one-hundred characteristics of their products and their
fifth meeting of the American Economic Association,
markets, considerable leeway to raise their
January 6, 1993, Anaheim, CA.
*Professor of Economics Emeritus, Columbia Uni- prices without unacceptable loss of sales.
versity, New York, NY 10027. This process is ultimately held in check only
>
< THE AMERICAN ECONOMIC REVIEW MARCH 1993
by the presence of underutilized labor and ing. An inflation rate assured to stay be-
other resources. Currently in the United tween 5 percent and 6 percent, say, might
States the NIARU appears to be around even have advantages. Monetary policy
4—6 percent. would be more powerful in stemming a
In some quarters this NIARU has even downturn in that very low and even negative
been termed the “natural” rate of unem- real rates of interest would become feasible
ployment, in one of the most vicious eu- as a stimulus to investment. It might in
phemisms ever coined. Some have even gone principle be easier to keep inflation within a
so far as to define ‘full employment” as l-percent range between 5 percent and
being the NIARU. But while 5-percent un- 6 percent, than to keep it within a 2-percent
employment might be barely tolerable if it range between — 1 percent and +1 percent,
meant that everyone would be taking an given the smaller real value of non-
additional two weeks of vacation every year interest-bearing moneys in circulation, even
without pay, it is totally unacceptable as a allowing for the superior political focusing
social goal when it means unemployment power of a target of 0 percent as compared
rates of 10, 20, or even 40 percent among to one of 5.5 percent.
disadvantaged groups, with resulting in- The base of the income tax would be
creases in poverty, homelessness, poor broadened also, making it possible to have a
health, drug addiction, and crime. Yet the tax that is more progressive and more pro-
hard political fact is that at such a NIARU ductive of revenue with lower marginal rates
the great majority of the voting population, and less of a distortionary effect. A tax
including most of the politically active up- based on nominal accrued income would in
per and middle classes, will have relatively effect be a tax on a base consisting of real
little personal experience of severe unem- income plus a percentage of net worth.
ployment, while nearly everyone will have While this is not what is meant by an ideo-
some direct experience of inflation. Many logically pure income tax, in terms of its
seem to feel that if only prices would stop practical effects it can be deemed a superior
rising they would benefit correspondingly by tax.
having their income go further, giving rela- It is the possibility of substantial changes
tively little thought to the effect on their in the rate of inflation, either up or down,
incomes. Even those with large mortgages that does the damage. Such changes involve
or other debts, who would actually gain a disappointment of expectations and a re-
from inflation, tend to concur in the notion distribution of wealth and income derived
that they suffer from it. It is thus extremely from a given national product that is capri-
difficult to get political support for anti- cious and often inequitable, but it does not
unemployment measures that are perceived of itself substantially reduce the amount to
as involving a threat of inflation, at least be distributed. Unemployment, on the other
until unemployment reaches 7 percent or hand, directly and definitely reduces the
more, at which point unemployment be- total product to be distributed. Unantici-
comes a more widespread threat. pated changes in the rate of inflation, up or
Actually it is the uncertainty as to the down, may be considered to be a form of
rate of inflation, and not its level, that does legitimized embezzlement, whereas unem-
the damage. An assured, moderate rate of ployment is vandalism.
inflation can be adapted to by adjusting Nevertheless, the stance of the politico-
nominal rates of interest and the terms of financial establishment is still to look at the
long-term contracts involving money pay- bottom line as the ultimate reality, whether
ments. The “menu cost” of changing price of the corporation or the national budget,
tags and catalog quotations is probably less and since money is the measure of all good
important than the mental effort required and evil in this kind of calculus, anything
of consumers in forming an idea of what an that impugns the value of money is viewed
appropriate current price is for infrequently as a kind of sacrilege reinforced by a lurking
purchased items, such as furniture or cloth- fear of starting down a slippery slope to
VOL. 83 NO. 1 VICKREY: TODAY’S TASK FOR ECONOMISTS
hyperinflation. We find the Federal Reserve income tax, which is by far the most serious
System poised to slam on the brakes at the hurdle in the way of private capital forma-
first sign of a resurgence of inflation, a tion of a kind requiring equity funding. Un-
posture not calculated to inspire investment like the capital-gains tax, the corporate in-
in durable capital. come tax is a tax largely above or before the
On the political side, we see the House market, requiring a rate of return on invest-
voting by a substantial majority in favor of a ment sufficient to cover the corporation tax
constitutional amendment to require a bal- and leave a rate of return after tax compa-
anced budget, fortunately falling short of rable to other investments, whereas the
the required two-thirds. This was done in capital-gains tax operates largely as a reduc-
spite of the fact that the nominal budget as tion in the return to the investor after or
currently computed is not a valid measure below the market, comparable to the reduc-
of any significant economic quantity. The tion of net income to the taxpayer resulting
nominal deficit would be reduced by selling from the personal income tax on other in-
the Pentagon to a life insurance company come. In addition, the corporation tax
subject to a long-term lease-back and repur- causes inefficient allocation of investment
chase option; this at least would do no between equity-type and loan-type invest-
harm, unlike the sale of natural resources to ments; it encourages thin equity and result-
private exploiters which would actually de- ing bankruptcies and reorganizations, and it
crease the real heritage handed down to the lubricates takeovers and mergers of dubious
future, on the pretext of reducing the trans- intrinsic merit.
fer requirements embodied in the national Reduction of the tax on capital gains, on
debt. the other hand, might actually depress eco-
nomic activity if the additional savings out
II. Recycling Savings Through Public of the tax reduction were to exceed the
Capital Formation additional capital formation induced. This is
the more likely in that most of the tax
From a classical standpoint, of course, reduction is likely to be saved immediately,
the difficulty is that no account is taken whereas the inducement to capital forma-
of the distinction between transactions on tion is in terms of a tax reduction in a
current account and on capital account. If relatively remote future, subject to legisla-
AT&T, General Motors, and households tive vicissitudes. At best, special treatment
had been constrained to operate under the of capital gains greatly increases the com-
restrictions of the proposed balanced-budget plexity of the tax law and diverts investment
amendment, we would now have far fewer flows from their most efficient use. There is
telephones, automobiles, and houses. A nothing to indicate that investments likely
capital budget, with a vast expansion of to yield returns in forms defined by the tax
government capital outlays on roads, code as capital gains will have any superior
bridges, research, education, and the like, social value: gains from land speculation, in
financed by borrowing, might go a consider- particular, add nothing to the real availabil-
able way toward improving the unemploy- ity of resources.
ment situation. But there is no assurance As for the corporate income tax, in spite
that it could do the whole job. of its many defects from the standpoint of
economic efficiency, it has enormous politi-
III. Eliminating the Corporation Income Tax cal popularity due to the fact that nearly
everyone thinks that it is paid by someone
Other classical approaches to improving else. Indeed economists have differed widely
the unemployment situation exist but have in their assignment of the “burden” of the
their own political opposition and in any tax, owing to a failure to specify, or even to
case are too weak to make much of a dent consider, the macroeconomic policy changes
in a very large need. One such measure necessarily involved in a change in the tax.
would be the abolition of the corporation Unlike most other taxes, the corporation tax
4 THE AMERICAN ECONOMIC REVIEW MARCH 1993
inflicts a double whammy on the economy the base for the progressive surtax paid by a
in that it both extracts income from the minority of taxpayers. It would still be ap-
stream of purchasing power and reduces the propriate to have an undistributed surplus
recycling of savings through investment. If tax to correspond to this surtax.
imposed on a revenue-neutral basis it causes
unemployment, while if a budgetary adjust- IV. Tax-Exempt Bonds
ment is made to maintain employment con-
stant, its burden can be thought of as falling Another measure that might slightly im-
on future wage earners, who will have less prove investment allocation would be to re-
capital with which to work. place the exemption of interest on state and
Problems of the deferral of income local bonds by a taxable tax credit at a rate
through undistributed profits, as well as the that would maintain the market value of the
deferral of taxation to the time of realiza- bonds. Low-bracket taxpayers would be lit-
tion of capital gains, would ideally be met tle affected, while the entire loss of revenue
by putting the personal income tax on a to th. Treasury would accrue as a subsidy to
cumulative basis, along lines I developed the issuers. Upper-bracket taxpayers would
while working with Carl Shoup in 1938, no longer have an incentive to invest in such
whereby the deferral of the reporting of bonds rather than in riskier investments
income, by whatever means, merely involves more suitable to their status.
the borrowing of the deferred tax at a suit-
able rate of interest. About two-thirds of V. Taxing Imputed Income
the internal revenue code would become
redundant, with the possible exception of A more important but politically more
the need to deal with the international jet difficult measure would be to require the
set and revolving-door marriages; large inclusion in taxable income of the rental
numbers of tax techies would be able to value of owner-occupied residences. This
apply themselves to more productive em- would not only improve the equity and pro-
ployment. gressivity of the income tax but go a sub-
Failing this, an approximation to a level stantial way toward making more units
playing field might be had by imposing a available for rental and, to a modest extent,
small annual tax on the accumulated undis- promoting the construction of additional
tributed surplus of corporations, roughly affordable rental housing and abating the
equal to the interest on the stockholders’ problem of homelessness. A similar case
postponed individual income tax. Similarly, can be made for including in the income tax
there should be a surcharge on realized base a net rental value of nonbusiness auto-
capital gains, proportionate to the length of mobiles (equal to interest on the market
time held, to offset the gain from the defer- value of the car), in this case reducing the
ral of the tax. discrimination against the use of public
If there is nevertheless a need to cater to transit.
a political demand for something that can
be labeled a corporation tax, this might be VI. Shifting Property Taxes from
satisfied by levying a corporation tax on Improvements to Land
dividends, interest, and retained earnings at
a rate corresponding to the first-bracket rate A measure that could provide a powerful
of the individual income tax and exempting stimulus to investment in property improve-
such interest and dividends from this “‘nor- ments would be to replace part or all of the
mal” rate, going back to the pre-1934 prac- property tax by a tax on land value only, a
tice of dividing the income tax into a normal proposal that can be traced all the way back
tax and a progressive surtax. To even things to Francois Quesnay and the French phys-
up neatly, normal tax paid on other forms of iocrats but which is more recently associ-
income should be deductible in computing ated with the name of Henry George. This