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Human Capital

To most people, capital means a bank account, a hundred shares of IBM stock, assembly lines, or steel plants in the Chicago area. These are all forms of capital in the sense that they are assets that yield income and other useful outputs over long periods of time. But such tangible forms of capital are not the only type of capital. Schooling, a computer training course, expenditures on medical care, and lectures on the virtues of punctuality and honesty are also capital. That is because they raise earnings, improve health, or add to a person’s good habits over much of his lifetime. Therefore, economists regard expenditures on education, training, medical care, and so on as investments in human capital. They are called human capital because people cannot be separated from their knowledge, skills, health, or values in the way they can be separated from their financial and physical assets. Education, training, and health are the most important investments in human capital. Many studies have shown that high school and college education in the United States greatly raise a person’s income, even after netting out direct and indirect costs of schooling, and even after adjusting for the fact that people with more education tend to have higher IQs and better-educated, richer parents. Similar evidence covering many years is now available from more than a hundred countries with different cultures and economic systems. The earnings of more-educated people are almost always well above average, although the gains are generally larger in less-developed countries. Consider the differences in average earnings between college and high school graduates in the United States during the past fifty years. Until the early 1960s, college graduates earned about 45 percent more than high school graduates. In the 1960s, this premium from college education shot up to almost 60 percent, but it fell back in the 1970s to less than 50 percent. The fall during the 1970s led some economists and the media to worry about “overeducated Americans.” Indeed, in 1976, Harvard economist Richard Freeman wrote a book titled The Overeducated American. This sharp fall in the return to investments caused doubt about whether education and training really do raise productivity or simply provide signals (“credentials”) about talents and abilities. But the monetary gains from a college education rose sharply again during the 1980s, to the highest level since the 1930s. Economists Kevin M. Murphy and Finis Welch have shown that the premium on getting a college education in the 1980s was above 65 percent. This premium continued to rise in the 1990s, and in 1997 it was more than 75 percent. Lawyers, accountants, engineers, and many other professionals experienced especially rapid advances in earnings. The earnings advantage of high school graduates over high school dropouts has also greatly increased. Talk about overeducated Americans has vanished, replaced by concern about whether the United States provides adequate quality and quantity of education and other training. This concern is justified. Real wage rates of young high school dropouts have fallen by more than 25 percent since the early 1970s. This drop is overstated, though, because the inflation measure used to compute real wages overstates the amount of inflation over that time (see consumer price indexes). Real wages for high school dropouts stayed constant from 1995 to 2004, which means, given the price index used to adjust them, that these wages have increased somewhat. Thinking about higher education as an investment in human capital helps us understand why the fraction of high school graduates who go to college increases and decreases from time to time. When the benefits of a college degree fell in the 1970s, for example, the fraction of white high school graduates who started college fell—from 51 percent in 1970 to 46 percent in 1975. Many educators expected that enrollments would continue to decline in the 1980s, partly because the number of eighteen-year-olds was declining, but also because college tuition was rising rapidly. They were wrong about whites. The fraction of white high school graduates who entered college rose steadily in the 1980s, reaching 60 percent in 1988, and caused an absolute increase in the number of whites enrolling despite the smaller number of college-aged people. That percentage kept increasing to an all-time high of 67 percent in 1997 and then declined slightly to 64 percent in 2000. This makes sense. The benefits of a college education, as noted, increased in the 1980s and 1990s. Tuition and fees did rise by about 39 percent from 1980 to 1986, and by 20 percent more from 1989 to 2000 in real, inflation-adjusted terms (again, using the faulty price indexes available). But tuition and fees are not, for most college students, the major cost of going to college. On average, three-fourths of the private cost of a college education—the cost borne by the student and the student’s family—is the income that college students give up by not working. A good measure of this “opportunity cost” is the income that a newly minted high school graduate could earn by working full time. During the 1980s and 1990s, this forgone income rose only about 4 percent in real terms. Therefore, even a 67 percent increase in real tuition costs in twenty years translated into an increase of just 20 percent in the average student’s total cost of a college education. The economics of human capital also account for the fall in the fraction of black high school graduates who went on to college in the early 1980s. As UCLA economist Thomas J. Kane has pointed out, costs rose more for black college students than for whites. That is because a higher percentage of blacks are from low-income families, and therefore had been heavily subsidized by the federal government. Cuts in federal grants to them in the early 1980s substantially raised their cost of a college education. In the 1990s, however, there was a substantial recovery in the percentage of black high school graduates going on to college. According to the 1982 “Report of the Commission on Graduate Education” at the University of Chicago, demo-graphic-based college enrollment forecasts had been wide of the mark during the twenty years prior to that time. This is not surprising to a “human capitalist.” Such forecasts ignored the changing incentives—on the cost side and on the benefit side—to enroll in college. The economics of human capital have brought about a particularly dramatic change in the incentives for women to invest in college education in recent decades. Prior to the 1960s, American women were more likely than men to graduate from high school, but less likely to go to college. Women who did go to college shunned or were excluded from math, sciences, economics, and law, and gravitated toward teaching, home economics, foreign languages, and literature. Because relatively few married women continued to work for pay, they rationally chose an education that helped in “household production”—and no doubt also in the marriage market—by improving their social skills and cultural interests. All this has changed radically. The enormous increase in the labor participation of married women is the most important labor force change during the past twenty-five years. Many women now take little time off from their jobs, even to have children. As a result, the value to women of market skills has increased enormously, and they are bypassing traditional “women’s” fields to enter accounting, law, medicine, engineering, and other subjects that pay well. Indeed, women now constitute about one-third of enrollments in business schools, more than 45 percent in law schools, and more than 50 percent in medical schools. Many home economics departments have either shut down or are emphasizing the “new home economics”—that is, the economics of whether to get married, how many children to have, and how to allocate household resources, especially time. Improvements in the economic position of black women have been especially rapid, and black women now earn almost as much as white women.1 Of course, formal education is not the only way to invest in human capital. Workers also learn and are trained outside schools, especially on the job. Even college graduates are not fully prepared for the labor market when they leave school and must be fitted into their jobs through formal and informal training programs. The amount of on-the-job training ranges from an hour or so at simple jobs like dishwashing to several years at complicated tasks like engineering in an auto plant. The limited data available indicate that on-the-job training is an important source of the very large increase in earnings that workers get as they gain greater experience at work. Bold estimates by Columbia University economist Jacob Mincer suggest that the total investment in on-the-job training may be well above $200 billion a year, or about 2 percent of GDP. No discussion of human capital can omit the influence of families on the knowledge, skills, health, values, and habits of their children. Parents affect educational attainment, marital stability, propensities to smoke and to get to work on time, and many other dimensions of their children’s lives. The enormous influence of the family would seem to imply a very close relation between the earnings, education, and occupations of parents and children. Therefore, it is rather surprising that the positive relation between the earnings of parents and children is not so strong, although the relation between the years of schooling of parents and their children is stronger. For example, if fathers earn 20 percent above the mean of their generation, sons at similar ages tend to earn about 8-10 percent above the mean of theirs. Similar relations hold in Western European countries, Japan, Taiwan, and many other places. Statisticians and economists call this “regression to the mean.” The old adage of “from shirtsleeves to shirtsleeves in three generations” (the idea being that someone starts with hard work and then creates a fortune for the next generation that is then dissipated by the third generation) is no myth; the earnings of grandsons and grandparents at comparable ages are not closely related.2 Apparently, the opportunities provided by a modern economy, along with extensive government and charitable support of education, enable the majority of those who come from lower-income backgrounds to do reasonably well in the labor market. The same opportunities that foster upward mobility for the poor create an equal amount of downward mobility for those higher up on the income ladder. The continuing growth in per capita incomes of many countries during the nineteenth and twentieth centuries is partly due to the expansion of scientific and technical knowledge that raises the productivity of labor and other inputs in production. And the increasing reliance of industry on sophisticated knowledge greatly enhances the value of education, technical schooling, on-the-job training, and other human capital. New technological advances clearly are of little value to countries that have very few skilled workers who know how to use them. Economic growth closely depends on the synergies between new knowledge and human capital, which is why large increases in education and training have accompanied major advances in technological knowledge in all countries that have achieved significant economic growth. The outstanding economic records of Japan, Taiwan, and other Asian economies in recent decades dramatically illustrate the importance of human capital to growth. Lacking natural resources—they import almost all their energy, for example—and facing discrimination against their exports by the West, these so-called Asian tigers grew rapidly by relying on a well-trained, educated, hardworking, and conscientious labor force that makes excellent use of modern technologies. China, for example, is progressing rapidly by mainly relying on its abundant, hardworking, and ambitious population. About the Author Gary S. Becker is university professor of economics and sociology at the University of Chicago, a professor at the Graduate School of Business, and the Rose-Marie and Jack R. Anderson Senior Fellow at Stanford’s Hoover Institution. He was a pioneer in the study of human capital and was awarded the 1992 Nobel Memorial Prize in Economic Sciences (see also biographies section). Further Reading   Becker, Gary S. Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education. 2d ed. New York: Columbia University Press for NBER, 1975. Freeman, Richard. The Overeducated American. New York: Academic Press, 1976. Kane, Thomas J. “College Attendance by Blacks Since 1970: The Role of College Cost, Family Background and the Returns to Education.” Journal of Political Economy 102 (1994): 878-911. Mincer, Jacob. “Investment in U.S. Education and Training.” NBER Working Paper no. 4844. National Bureau of Economic Research, Cambridge, Mass., 1994. Murphy, Kevin M., and Finis Welch. “Wage Premiums for College Graduates: Recent Growth and Possible Explanations.” Educational Researcher 18 (1989): 17-27. National Center for Education Statistics. “Digest of Education Statistics 2001.” NCES 2002-130. U.S. Department of Education, March 2002. National Center for Education Statistics. “Paying for College—Changes Between 1990 and 2000 for Full-Time Dependent Undergraduates.” NCES 2004-075. U.S. Department of Education, June 2004. National Center for Education Statistics. “Projections of Education Statistics to 2012.” NCES 2002-030. U.S. Department of Education, October 2002. “Report of the Commission on Graduate Education.” University of Chicago Record 16, no. 2 (1982): 67-180. Topel, Robert. “Factor Proportions and Relative Wages: The Supply Side Determinants of Wage Inequality.” Journal of Economic Perspectives II (Spring 1997): 55-74. Welch, Finis, ed. The Causes and Consequences of Increasing Inequality. Bush School Series in the Economics of Public Policy. Chicago: University of Chicago Press, 2001.   Footnotes 1. National Center for Education Statistics, “Educational Achievement and Black-White Inequality,” NCES 2001-061, U.S. Department of Education, 2001.   2. Gary Solon, “Intergenerational Income Mobility in the United States,” American Economic Review 82 (June 1992): 393-408.   (0 COMMENTS)

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Game Theory

Game theory is the science of strategy. It attempts to determine mathematically and logically the actions that “players” should take to secure the best outcomes for themselves in a wide array of “games.” The games it studies range from chess to child rearing and from tennis to takeovers. But the games all share the common feature of interdependence. That is, the outcome for each participant depends on the choices (strategies) of all. In so-called zero-sum games the interests of the players conflict totally, so that one person’s gain always is another’s loss. More typical are games with the potential for either mutual gain (positive sum) or mutual harm (negative sum), as well as some conflict. Game theory was pioneered by Princeton mathematician john von neumann. In the early years the emphasis was on games of pure conflict (zero-sum games). Other games were considered in a cooperative form. That is, the participants were supposed to choose and implement their actions jointly. Recent research has focused on games that are neither zero sum nor purely cooperative. In these games the players choose their actions separately, but their links to others involve elements of both competition and cooperation. Games are fundamentally different from decisions made in a neutral environment. To illustrate the point, think of the difference between the decisions of a lumberjack and those of a general. When the lumberjack decides how to chop wood, he does not expect the wood to fight back; his environment is neutral. But when the general tries to cut down the enemy’s army, he must anticipate and overcome resistance to his plans. Like the general, a game player must recognize his interaction with other intelligent and purposive people. His own choice must allow both for conflict and for possibilities for cooperation. The essence of a game is the interdependence of player strategies. There are two distinct types of strategic interdependence: sequential and simultaneous. In the former the players move in sequence, each aware of the others’ previous actions. In the latter the players act at the same time, each ignorant of the others’ actions.

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Futures and Options Markets

Futures Markets In the late 1970s and early 1980s, radical changes in the international currency system and in the way the Federal Reserve managed the U.S. money supply produced unprecedented volatility in interest rates and currency exchange rates. As market forces shook the foundations of global financial stability, businesses wrestled with heretofore unimagined challenges. Between 1980 and 1985, Caterpillar, the Peoria-based maker of heavy equipment, saw exchange-rate shifts give its main Japanese competitor a 40 percent price advantage. Meanwhile, even the soundest business borrowers faced soaring double-digit interest rates. Investors clamored for dollars as commodity prices collapsed, taking whole nations down into insolvency and ushering in the Third World debt crisis. Stymied financial managers turned to Chicago, where the traditional agricultural futures markets had only recently invented techniques to cope with financial uncertainty. In 1972, the Chicago Mercantile Exchange established the International Monetary Market to trade the world’s first futures contracts for currency. The world’s first interest-rate futures contract was introduced shortly afterward, at the Chicago Board of Trade, in 1975. In 1982, futures contracts on the Standard and Poor’s 500 index began to trade at the Chicago Mercantile Exchange. These radically new tools helped businesses manage in a volatile and unpredictable new world order. How? Futures are standardized contracts that commit parties to buy or sell goods of a specific quality at a specific price, for delivery

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Gender Gap

When economists speak of the “gender gap” these days, they usually are referring to systematic differences in the outcomes that men and women achieve in the labor market. These differences are seen in the percentages of men and women in the labor force, the types of occupations they choose, and their relative incomes or hourly wages. These economic gender gaps, which were salient issues during the women’s movement in the 1960s and 1970s, have been of interest to economists at least since the 1890s. Figure 1 Labor Force Participation Rates of Men and Women, 25-44 Years Old, 1890-2000

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German Economic Miracle

After World War II the German economy lay in shambles. The war, along with Hitler’s scorched-earth policy, had destroyed 20 percent of all housing. Food production per capita in 1947 was only 51 percent of its level in 1938, and the official food ration set by the occupying powers varied between 1,040 and 1,550 calories per day. Industrial output in 1947 was only one-third its 1938 level. Moreover, a large percentage of Germany’s working-age men were dead. At the time, observers thought that West Germany would have to be the biggest client of the U.S. welfare state; yet, twenty years later its economy was envied by most of the world. And less than ten years after the war people already were talking about the German economic miracle. What caused the so-called miracle? The two main factors were currency reform and the elimination of price controls, both of which happened over a period of weeks in 1948. A further factor was the reduction of marginal tax rates later in 1948 and in 1949. Before By 1948 the German people had lived under price controls for twelve years and rationing for nine years. Adolf Hitler had imposed price controls on the German people in 1936 so that his government could buy war materials at artificially low prices. Later, in 1939, one of Hitler’s top Nazi deputies, Hermann Goering, imposed rationing. (Roosevelt and Churchill also imposed price controls and rationing, as governments tend to do during all-out wars.) During the war, the Nazis made flagrant violations of the price controls subject to the death penalty.1 In November 1945 the Allied Control Authority, formed by the governments

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Global Warming: A Balance Sheet

We live in a greenhouse world; without such gases Earth would be too cold to sustain life as we know it. Water vapor, the principal molecule that keeps us warm, accounts for almost all (98 percent) of the natural heating of the world. Other gases, such as carbon dioxide (CO2), methane (CH4), and nitrous oxide (N2O), also contribute to a warmer world. Over the last three hundred years, as the world has industrialized and become more and more dependent on fossil fuels, the concentration of CO2 in the atmosphere has increased by more than 30 percent while methane concentrations, mainly from agriculture, have increased by about 150 percent. Atmospheric scientists have predicted that increases in those greenhouse gases will lead to, or are already producing, a warmer world. The Intergovernmental Panel on Climate Change (IPCC, a UN body tasked with the science of global warming) believes that if nothing is done to slow global warming, the amount of CO2 will have doubled by the year 2060, causing the world’s temperature to rise by about 2.5°C (4.5°F). Interestingly, Swedish scientist Svante Arrhenius, the first to predict global warming (1896), believed that it would be beneficial, especially for northern countries. In 1992, however, the fear of harm from global warming led most of the world’s national governments, including the U.S. government, to sign the United Nations Framework Convention on Climate Change at the Earth Summit in Rio de Janeiro. These governments pledged to take voluntary steps to cap carbon emissions at 1990 levels by the year 2000. The U.S. Senate ratified that treaty later in 1992. International activity continued with a subsequent meeting in Berlin (1995), followed by the meeting in Kyoto (1997) that negotiated a protocol mandating emission reductions by the advanced countries of the world but exempting the rest of the globe. The Clinton administration signed the protocol, knowing that with large countries like China and India excluded, the Senate would be unlikely to ratify it. Indeed, President Clinton refused to send the protocol to the Senate for ratification, and the Senate voted 95–0 against any treaty that excluded some countries. Shortly after taking office, George W. Bush announced that the United States was withdrawing from the treaty on the

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Government Debt and Deficits

Government debt is the stock of outstanding IOUs issued by the government at any time in the past and not yet repaid. Governments issue debt whenever they borrow from the public; the magnitude of the outstanding debt equals the cumulative amount of net borrowing that the government has done. The deficit is the addition in the current period (year, quarter, month, etc.) to the outstanding debt. The deficit is negative whenever the value of outstanding debt falls; a negative deficit is called a surplus. When the government borrows, it gives its creditors government securities stating the terms of the loan: the principal being borrowed, the interest rate to be paid on the principal, and the schedule for making the interest payments and principal repayment. The amount of outstanding securities equals the amount of debt that has not yet been repaid; that amount is called “the government debt.” Governments issue several types of debt, which can be classified in various ways. One classification is by the type of government that issued the debt. In the United States, the main divisions are federal, state, and local debt; local debt can be divided further by type of locality, such as county or city (see bonds). A second classification of government debt is by maturity at the time of issue. When we talk about a ten-year bond or a thirty-year bond, we are talking about the length of time between the date when the bond was first issued and the date on which the principal will be repaid. Federal debt is divided into three convenient maturity categories. Treasury bills have initial maturities of one year or less (“three-month bills,” “year bills,” etc.); treasury notes have initial maturities between one and ten years; and treasury bonds have initial maturities longer than ten years. State and local government securities generally are just called bonds, irrespective of the initial maturity. A perpetuity is a bond with an infinite maturity, which means the principal is never repaid and interest payments are made forever. The British government once issued perpetuities, calling them “consols.” A third way of classifying government securities is by the source of the revenue to repay them. “General obligation bonds” will be repaid with revenue collected by taxing the public; “revenue bonds” will be repaid with revenue collected from specific user fees, such as bridge or highway tolls. This way of classifying debt is used only for state and local debt. In early 2004, there was about $7.1 trillion of federal debt outstanding. About half ($3.6 trillion) was held by federal agencies and trust funds, which means that the government owed half the debt to itself. Such internal debt has no implications for the economy or public welfare. The important number is the amount of federal debt held by private investors, which in early 2004 was about $3.5 trillion. Foreigners held about $1.7 trillion of that amount. State and local government debt outstanding was another $1.6 trillion, most of which was held by private investors. Thus, the total amount of privately held government debt was about $5.1 trillion. As a fraction of gross domestic product (GDP) of the U.S. economy, government debt is not especially large. As of the end of 2003, GDP was about $11.1 trillion, a little more than twice the size of the privately held government debt. In contrast, at the end of World War II, outstanding federal debt alone was slightly larger than GDP. Another interesting comparison is between government debt and private debt. Corporate debt outstanding was about $5.0 trillion at the end of 2003, almost exactly the same amount as privately held government debt. Household debt is even larger. At the end of 2003, household credit market debt stood at $9.5 trillion, nearly twice the size of privately held government debt. For some reason, attitudes toward these different stocks of debt are somewhat inconsistent. Commentators regularly express concern that the sizes of government and household debt represent a risk to the economy, yet no one seems to worry much about the size of corporate debt. In fact, household and corporate debt may represent a risk in some circumstances, but government debt essentially never does. In a deep recession, debtors may become unable to repay their debts and choose to default on them. That, in turn, can make financial institutions insolvent, leading to a collapse of the financial system and a cessation of the intermediary functions that they perform. Indeed, such a mechanism was the proximate cause for the recession of 1929 turning into the great depression of 1932. Rarely, however, does any government in the United States default on its debt; the federal government has never defaulted. The size of the outstanding government debt is a topic of perennial interest. The obvious measurement of the debt’s size is the sum of all the individual outstanding government securities. That number often is reported in newspaper accounts and political debates, but, to be useful, it must be adjusted. The most important adjustment is for inflation. The nominal value of a bond is the price in dollars that it would fetch on the open market. The real value of that same bond is the number of units of output that it can buy. If chocolate bars cost twenty-five cents apiece, then the real value of a ten-dollar bond is forty chocolate bars. If, however, the prices of all goods double, so that chocolate bars now cost fifty cents each, then the real value of the same ten-dollar bond is cut in half, and the bond now buys only twenty chocolate bars. The bond’s nominal value is unchanged by inflation, but its real value is changed. Real, not nominal, values are what matters because people are interested in how many goods they can buy with the wealth their bonds represent—which is precisely what the real value measures. Adjusting official debt and deficit figures for inflation can make a big difference to measurements of the debt’s size. For example, the official statistics report a federal surplus of $6.6 billion for 1947. Inflation that year was nearly 15 percent, however, and this inflation reduced the value of the huge outstanding debt by about $11.4 billion. That reduction was equivalent to a further surplus because it reduced the real value of what the federal government owed its creditors. The true surplus, therefore, was about $18 billion, nearly three times as high as the official figure. Throughout the 1970s, while the official federal deficit was positive every year, the inflation-corrected deficit was negative (i.e., there was a real surplus) in exactly half those years. Another adjustment is for changes in interest rates. The value of outstanding debt changes as market interest rates change, but newspaper accounts usually report par values, which do not adjust for interest rate changes. Market values do account for interest rate changes and can be quite different from par values. To see what is involved, suppose that you buy a one-year $5,000 municipal bond (equivalently, you make a loan of $5,000 to the city that issued the bond) at 11:00 a.m. The bond carries an interest rate of 10 percent, which means you will be paid $500 in interest when the bond matures one year from now. At 11:05 a.m., the Federal Reserve announces a change in monetary policy that causes one-year interest rates to fall to 9 percent. Your bond now is worth more than it was when you bought it five minutes ago; that is, you could now sell the bond to someone else for more than $5,000. The reason is that anyone who wants to lend $5,000 for one year now will find that new bonds pay only 9 percent, meaning an interest payment in one year of $450. Your “old” bond, however, has a 10 percent rate locked in and will pay $500 interest for sure. That makes your bond’s market value higher than its par value of $5,000. Conversion to market value can raise or lower the size of the outstanding debt. The market value of outstanding debt will be greater than the par value if interest rates have fallen on average since the debt was issued and will be smaller than the par value if rates have risen. The difference between par value and market value of the outstanding debt is typically a few percentage points. Unfortunately, market values for the total outstanding government debt are not readily available. Governments do not report them, which is why newspaper reports rarely mention them. More important than the sheer size of government debt are the debt’s effects on the economy. Economists do not fully agree on what those effects are. When the government borrows, it promises to repay the lender. To make those repayments the government ultimately will have to raise extra taxes, beyond what it needs to pay for its other activities. The economic effect of government debt depends heavily on how taxpayers perceive those future taxes. Perceptions are difficult to measure, and neither economists nor others understand exactly how people form their perceptions. To see what is at issue, consider a simple example. Suppose that every year the government buys $100 billion worth of goods and services and pays for them entirely by collecting taxes. Households pay the government $100 billion in tax revenue, and the government uses the revenue to buy goods and services. Revenue equals expenditure, so the government’s budget is balanced. Suppose the government suddenly decides to change the way it finances its expenditures, but not the amount spent. In the first year, the government reduces taxes by $10 billion and replaces the lost revenue by selling $10 billion worth of bonds that mature in one year and carry an interest rate of 10 percent a year. In the second year, the bonds mature, and the government pays the $10 billion principal and the $1 billion of interest. Taxes in the first year are $10 billion lower, but in the second year they are $11 billion higher. How does this temporal rearrangement of tax collections affect people? In the first year, people hand over the same revenue to the government as they did when they paid taxes; the difference is that $10 billion of it is now in the form of a loan that will be repaid in the second year with an extra $1 billion in interest. On this account, people may feel richer because they seem to be paying less in total taxes over the two periods. When the second year arrives, however, people will find that they have nothing extra at all because, to pay the $11 billion in principal and interest, the government must raise taxes by exactly $11 billion, which cancels the payment of the principal and interest. The government giveth with one hand and taketh away with the other. The net result is that people do not get back the $10 billion they lent the government, and the loan is equivalent to having paid the $10 billion in taxes in the first year. This same result emerges from any maturity of debt, whether it is a one-year bond, as in the previous example, a ten-year bond, or even a perpetuity. The crucial factor in determining how bond finance affects the economy is whether people recognize what is going to happen over time. If everybody foresees that future taxes will nullify future payments of principal and interest, then bond finance is equivalent to tax finance, and government debt has no effect on anything important. This property is known as “Ricardian equivalence,” after David Ricardo, the economist who first discussed it. If people do not foresee all the future taxes implied by government debt, then they feel wealthier when the debt is issued but poorer in the future when, unexpectedly, they have to pay higher taxes to finance the principal and interest payments. So, what do people expect? Unfortunately, there is no reliable way to discover people’s expectations about taxes, and we have to use other methods to learn the effect of government debt on the economy. Even though economists have been studying this issue for more than twenty years, they have not yet reached a consensus. Direct measures of the effect of debt on economic activity are straightforward in principle but difficult to construct in practice. Overall, though, the evidence favors approximate Ricardian equivalence. If government debt is equivalent to taxation, then most of the public discussion of the “deficit problem” is misplaced. Under equivalence, government deficits merely rearrange the timing of tax collections in a way that people can anticipate and offset; no important economic effects arise. With incomplete equivalence, deficits affect the economy, but the effects are complicated. For example, suppose people do not recognize any of the future taxes implied by current deficits. In that case, partially replacing current tax collections with borrowing makes people feel wealthier today, which induces them to spend more; however, the taxes needed to repay the debt will eventually have to be collected. Because no one anticipated them, they will come as a surprise, inducing people unexpectedly to spend less in whatever period the taxes are levied. A deficit or surplus thus has effects not just in the period when the deficit or surplus occurs, but also in subsequent periods. Predicting the magnitude and timing of the sequence of effects is difficult. A related issue is the desirability of deliberately using deficits to influence the path of the economy. Under full equivalence of deficit and tax finance, no such thing can be done, of course, because deficits do not affect anything important. Under incomplete equivalence, though, deficits do have effects, as we have just seen. Therefore, it might seem desirable to run up deficits in recessions to encourage people to spend more and to run up surpluses in booms to restrain spending. One problem is that these seemingly desirable effects arise only because people fail to perceive the future taxes implied by deficits; that is, deficits have effects only when they fool people into thinking they suddenly have become wealthier (and conversely for surpluses). Is it desirable to influence the path of the economy by using a policy that is effective only because it deliberately misleads the public? Such a proposition seems difficult to justify. Another problem is that any desirable effects are accompanied by other effects that might not be deemed desirable. When equivalence is incomplete, changing the stock of debt outstanding also changes the interest rate in the same direction. In particular, running a deficit in a recession would raise interest rates, which would reduce investment and economic growth, which in turn would reduce output in the future. Thus, using deficits to stimulate the economy now to ameliorate a recession comes at the cost of reducing output later. Whether that is a good exchange is not obvious and requires justification. About the Author John Seater is a professor of economics in the College of Management at North Carolina State University and a Sloan Fellow of the Wharton Financial Institutions Center of the University of Pennsylvania. He was formerly a senior economist in the Research Department of the Federal Reserve Bank of Philadelphia. Further Reading   Barro, Robert J. “The Ricardian Approach to Budget Deficits.” Journal of Economic Perspectives 3 (Spring 1989): 37-54. Butkiewicz, James L. “The Market Value of Outstanding Government Debt: Comment.” Journal of Monetary Economics 11 (May 1983): 373-379. Cox, W. Michael. “The Behavior of Treasury Securities: Monthly, 1942-1984.” Journal of Monetary Economics 16 (September 1985): 227-240. Eisner, Robert. “Budget Deficits: Rhetoric and Reality.” Journal of Economic Perspectives 3 (Spring 1989): 73-93. Ricciuti, Roberto. “Assessing Ricardian Equivalence.” Journal of Economic Surveys 17 (February 2003): 55-78. Seater, John J. “The Market Value of Outstanding Government Debt, 1919-1975.” Journal of Monetary Economics 8 (July 1981): 85-101. Seater, John J. “Ricardian Equivalence.” Journal of Economic Literature 31 (March 1993): 142-190.   (0 COMMENTS)

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Gold Standard

The gold standard was a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price. England adopted a de facto gold standard in 1717 after the master of the mint, Sir Isaac Newton, overvalued the guinea in terms of silver, and formally adopted the gold standard in 1819. The United States, though formally on a bimetallic (gold and silver) standard, switched to gold de facto in 1834 and de jure in 1900 when Congress passed the Gold Standard Act. In 1834, the United States fixed the price of gold at $20.67 per ounce, where it remained until 1933. Other major countries joined the gold standard in the 1870s. The period from 1880 to 1914 is known as the classical gold standard. During that time, the majority of countries adhered (in varying degrees) to gold. It was also a period of unprecedented economic growth with relatively free trade in goods, labor, and capital. The gold standard broke down during World War I, as major belligerents resorted to inflationary finance, and was briefly reinstated from 1925 to 1931 as the Gold Exchange Standard. Under this standard, countries could hold gold or dollars or pounds as reserves, except for the United States and the United Kingdom, which held reserves only in gold. This version broke down in 1931 following Britain’s departure from gold in the face of massive gold and capital outflows. In 1933, President Franklin D. Roosevelt nationalized gold owned by private citizens and abrogated contracts in which payment was specified in gold. Between 1946 and 1971, countries operated under the Bretton Woods system. Under this further modification of the gold standard, most countries settled their international balances in U.S. dollars, but the U.S. government promised to redeem other central banks’ holdings of dollars for gold at a fixed rate of thirty-five dollars per ounce. Persistent U.S. balance-of-payments deficits steadily reduced U.S. gold reserves, however, reducing confidence in the ability of the United States to redeem its currency in gold. Finally, on August 15, 1971, President Richard M. Nixon announced that the United States would no longer redeem currency for gold. This was the final step in abandoning the gold standard. Widespread dissatisfaction with high inflation in the late 1970s and early 1980s brought renewed interest in the gold standard. Although that interest is not strong today, it seems to strengthen every time inflation moves much above 5 percent. This makes sense: whatever other problems there were with the gold standard, persistent inflation was not one of them. Between 1880 and 1914, the period when the United States was on the “classical gold standard,” inflation averaged only 0.1 percent per year. How the Gold Standard Worked The gold standard was a domestic standard regulating the quantity and growth rate of a country’s money supply. Because new production of gold would add only a small fraction to the accumulated stock, and because the authorities guaranteed free convertibility of gold into nongold money, the gold standard ensured that the money supply, and hence the price level, would not vary much. But periodic surges in the world’s gold stock, such as the gold discoveries in Australia and California around 1850, caused price levels to be very unstable in the short run. The gold standard was also an international standard determining the value of a country’s currency in terms of other countries’ currencies. Because adherents to the standard maintained a fixed price for gold, rates of exchange between currencies tied to gold were necessarily fixed. For example, the United States fixed the price of gold at $20.67 per ounce, and Britain fixed the price at £3 17s. 10½ per ounce. Therefore, the exchange rate between dollars and pounds—the “par exchange rate”—necessarily equaled $4.867 per pound. Because exchange rates were fixed, the gold standard caused price levels around the world to move together. This comovement occurred mainly through an automatic balance-of-payments adjustment process called the price-specie-flow mechanism. Here is how the mechanism worked. Suppose that a technological innovation brought about faster real economic growth in the United States. Because the supply of money (gold) essentially was fixed in the short run, U.S. prices fell. Prices of U.S. exports then fell relative to the prices of imports. This caused the British to demand more U.S. exports and Americans to demand fewer imports. A U.S. balance-of-payments surplus was created, causing gold (specie) to flow from the United Kingdom to the United States. The gold inflow increased the U.S. money supply, reversing the initial fall in prices. In the United Kingdom, the gold outflow reduced the money supply and, hence, lowered the price level. The net result was balanced prices among countries. The fixed exchange rate also caused both monetary and

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Free Market

“Free market” is a summary term for an array of exchanges that take place in society. Each exchange is undertaken as a voluntary agreement between two people or between groups of people represented by agents. These two individuals (or agents) exchange two economic goods, either tangible commodities or nontangible services. Thus, when I buy a newspaper from a newsdealer for fifty cents, the newsdealer and I exchange two commodities: I give up fifty cents, and the newsdealer gives up the newspaper. Or if I work for a corporation, I exchange my labor services, in a mutually agreed way, for a monetary salary; here the corporation is represented by a manager (an agent) with the authority to hire. Both parties undertake the exchange because each expects to gain from it. Also, each will repeat the exchange next time (or refuse to) because his expectation has proved correct (or incorrect) in the recent past. Trade, or exchange, is engaged in precisely because both parties benefit; if they did not expect to gain, they would not agree to the exchange. This simple reasoning refutes the argument against free trade typical of the “mercantilist” period of sixteenth- to eighteenth-century Europe and classically expounded by the famed sixteenth-century French essayist Montaigne. The mercantilists argued that in any trade, one party can benefit only at the expense of the other—that in every transaction there is a winner and a loser, an “exploiter” and an “exploited.” We can immediately see the fallacy in this still-popular viewpoint: the willingness and even eagerness to trade means that both parties benefit. In modern game-theory jargon, trade is a win-win situation, a “positive-sum” rather than a “zero-sum” or “negative-sum” game. How can both parties benefit from an exchange? Each one values the two goods or services differently, and these differences set the scene for an exchange. I, for example, am walking along with money in my pocket but no newspaper; the newsdealer, on the other hand, has plenty of newspapers but is anxious to acquire money. And so, finding each other, we strike a deal. Two factors determine the terms of any agreement: how much each participant values each good in question, and each participant’s bargaining skills. How many cents will exchange for one newspaper, or how many Mickey Mantle baseball cards will swap for a Babe Ruth, depends on all the participants in the newspaper market or the baseball card market—on how much each one values the cards as compared with the other goods he could buy. These terms of exchange, called “prices” (of newspapers in terms of money, or of Babe Ruth cards in terms of Mickey Mantles), are ultimately determined by how many newspapers, or baseball cards, are available on the market in relation to how favorably buyers evaluate these goods—in shorthand, by the interaction of their supply with the demand for them. Given the supply of a good, an increase in its value in the minds of the buyers will raise the demand for the good, more money will be bid for it, and its price will rise. The reverse occurs if the value, and therefore the demand, for the good falls. On the other hand, given the buyers’ evaluation, or demand, for a good, if the supply increases, each unit of supply—each baseball card or loaf of bread—will fall in value, and therefore the price of the good will fall. The reverse occurs if the supply of the good decreases. The market, then, is not simply an array; it is a highly complex, interacting latticework of exchanges. In primitive societies, exchanges are all barter or direct exchange. Two people trade two directly useful goods, such as horses for cows or Mickey Mantles for Babe Ruths. But as a society develops, a step-by-step process of mutual benefit creates a situation in which one or two broadly useful and valuable commodities are chosen on the market as a medium of indirect exchange. This money-commodity, generally but not always gold or silver, is then demanded not only for its own sake, but even more to facilitate a reexchange for another desired commodity. It is much easier to pay steelworkers not in steel bars but in money, with which the workers can then buy whatever they desire. They are willing to accept money because they know from experience and insight that everyone else in the society will also accept that money in payment. The modern, almost infinite latticework of exchanges, the market, is made possible by the use of money. Each person engages in specialization, or a division of labor, producing what he or she is best at. Production begins

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Foreign Exchange

The foreign exchange market is the market in which foreign currency—such as the yen or euro or pound—is traded for domestic currency—for example, the U.S. dollar. This “market” is not in a centralized location; instead, it is a decentralized network that is nevertheless highly integrated via modern information and telecommunications technology. According to a triennial survey, the average daily global turnover (i.e., amount exchanged) in traditional foreign exchange markets reached $1.9 trillion in April 2004.1 In addition, there was $1.2 trillion of trading in derivatives such as forwards and options (see futures and options markets). In the spot market, parties contract for delivery of the foreign exchange immediately. In the forward market, they contract for delivery at some point, such as three months, in the future. In the option market, they enter a contract that allows one party to buy or sell foreign exchange in the future, but does not require it (thus the word “option”). Most of the trading is among banks, either on behalf of customers or on their own account. The counterparty to the transaction could be another dealer, another financial institution, or a nonfinancial customer. The survey reported that 89 percent of the trading involved the dollar on one side of the transaction or the other. (That the dollar is used as a “vehicle currency” explains why its trading volume is so high: someone wanting to go from the Malaysian ringgit to the South African rand passes through the dollar on the way.) Next, 37 percent of foreign exchange transactions involved the euro, 20 percent the yen, 17 percent the British pound, 6 percent the Swiss franc, 5 percent the Australian dollar, and 4 percent the Canadian dollar. London is the world’s largest center for trading foreign exchange, with 31 percent of the global total turnover. Next comes New York at 19 percent, Tokyo at 8 percent, and Singapore and Frankfurt at 5 percent each. The exchange rate is the price of foreign currency. For example, the exchange rate between the British pound and the U.S. dollar is usually stated in dollars per pound sterling ($/£); an increase in this exchange rate from, say, $1.80 to say, $1.83, is a depreciation of the dollar. The exchange rate between the Japanese yen and the U.S. dollar is usually stated in yen per dollar (¥/$); an increase in this exchange rate from, say, ¥108 to ¥110 is an appreciation of the dollar. Some countries “float” their exchange rate, which means that the central bank (the country’s monetary authority) does not buy or sell foreign exchange, and the price is instead determined in the private marketplace. Like other market prices, the exchange rate is determined by supply and demand—in this case, supply of and demand for foreign exchange. Some countries’ governments, instead of floating, “fix” their exchange rate, at least for periods of time, which means that the government’s central bank is an active trader in the foreign exchange market. To do so, the central bank buys or sells foreign currency, depending on which is necessary to peg the currency at a fixed exchange rate with the chosen foreign currency. An increase in foreign exchange reserves will add to the money supply, which could lead to inflation if it is not offset by the monetary authorities via what are called “sterilization” operations. Sterilization by the central bank means responding to increases in reserves so as to leave the total money supply unchanged. A common way to accomplish it is by selling bonds on the open market; a less common way is to increase the reserve requirements placed on commercial banks. Still other countries follow some regime intermediate between pure fixing and pure floating (examples include bands or target zones, basket pegs, crawling pegs, and adjustable pegs). Many central banks practice “managed floating,” whereby they intervene in the foreign exchange market by “leaning against the wind.” To do so, a central bank sells foreign exchange when the exchange rate is going up, thereby dampening its rise, and buys when it is going down. The motive is to reduce the variability in the exchange rate. Private speculators may do the same thing:

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