The NBER Reporter Winter 2005: Conferences

Winter 2005
Japan Conference
Globalization and Poverty
Tax Policy and the Economy
The Risks of Financial Institutions
International Transmission and Comovement

Japan Conference

The NBER together with the Centre for Economic Policy Research, Center for International Research on the Japanese Economy, and European Institute of Japanese Studies jointly organized a conference on the Japanese economy in Tokyo on September 1-2. The co-chairs of the meeting were: Magnus Blomstrom, NBER and Stockholm School of Economics; Jennifer Corbett, Australian National Union; Fumio Hayashi, NBER and the University of Tokyo; Charles Horioka, Osaka University; Anil K Kashyap, NBER and the Graduate School of Business, University of Chicago; and David Weinstein, NBER and Columbia University. The following papers were discussed:

Daiji Kawaguchi, University of Tsukuba, and Wenjie Ma, Osaka University, "The Causal Effect of Graduating from a Top University on Promotion: Evidence from the University of Tokyo's Admission Freeze in 1969"
Discussant: Edward Miguel, NBER and University of California, Berkeley

Hiroshi Ono, Stockholm School of Economics, and Kazuhiko Odaki, Ministry of Economy, Trade and Industry, "Foreign Ownership and the Structure of Wages in Japan"
Discussant: Marianne Bertrand, NBER and University of Chicago

Kazuo Ogawa, Osaka University, "Debt, R and D Investment, and Technological Progress: A Panel Study of Japanese Manufacturing Firms in the 1990s"
Discussant: Lee G. Branstetter, NBER and Columbia University

Kathryn L. Dewenter and Alan C. Hess, University of Washington, and Yasushi Hamao, University of Southern California, "Are the Major Japanese Banks Uniform or Unique?"
Discussant: Joe Peek, University of Kentucky

Heather Montgomery, Asian Development Bank Institute, and Satoshi Shimizutani, Cabinet Office, "The Effectiveness of Bank Recapitalization in Japan"
Discussant: Randall S. Kroszner, NBER and University of Chicago

Fumio Hayashi, and Edward C. Prescott, Federal Reserve Bank of Minneapolis, "The Depressing Effect of Agriculture Institutions on the Prewar Japanese Economy"
Discussant: John Fernald, Federal Reserve Bank of Chicago

Daniel Leigh, Johns Hopkins University, "Monetary Policy and the Dangers of Deflation: Lessons from Japan"
Discussant: Alan J. Auerbach, NBER and University of California, Berkeley

Wako Watanabe, Osaka University, "Prudential Regulation, the 'Credit Crunch' and the Ineffectiveness of Monetary Policy: Evidence from Japan"
Discussant: Takeo Hoshi, NBER and University of California, San Diego

The high correlation between graduating from a selective college and success in the labor market has been observed in many countries. There are two major explanations for this finding: either graduating from selective colleges causes success in the labor market because of better education, a better alumni network, or something attached to selective college graduation, or the correlation is created by a "third" factor, such as selective college graduates' high innate ability, or better family background. Kawaguchi and Ma attempt to test the latter hypothesis by using a natural experiment. The most selective university in Japan, the University of Tokyo, did not admit new students in 1969 because the university could not administer its entrance examination; there was a campus lockout by armed, leftist students, who demanded university reform. Consequently, many of the 3,000 high school graduates who would have been admitted to the university went to other, second-best universities that year. The authors ask whether the 1973 graduation cohort of these secondbest universities performed better than other graduation cohorts of the same universities. Using the 2002 Who's Who for publicly traded companies and the central government, they find little evidence that the 1973 graduating cohort from the second-best universities performed better than other cohorts. This finding rejects the hypothesis that the Tokyo graduates' success is explained solely by their innate high ability.

Ono and Odaki examine differences in the wage structure of domestic versus foreign-owned establishments in Japan. Using high-quality wage datasets from the Japanese government, they construct a large employer-employee matched database consisting of 50,000 establishments matched with a sample of approximately one million workers in 1998. Their results confirm that foreign-owned establishments in Japan pay higher wages than domestic establishments, even after they account for human capital and industry composition. A single percentage point increase in the foreign ownership share of equity is associated with a 0.3 percent increase in wages. These results also highlight the distinction in the structure of wages between domestic and foreign-owned establishments. Tenure effects on wages are considerably weaker among foreign-owned establishments, where wages are determined more by general skills as observed by the higher returns to education and work experience. Women in foreign-owned establishments earn more than women in domestic establishments, resulting in a smaller gender wage gap among foreign-owned establishments. Given the high degree of gender segregation and the lack of long-term prospects for women in Japan, foreign-owned establishments may be one source of "brain-drain" for highly-skilled women in the Japanese labor market.

Based on a panel dataset of Japanese manufacturing firms in research-intensive industries, Ogawa investigates the extent to which outstanding debt in the 1990s affected firms' R and D activities. He finds that massive debt had a significantly negative effect on R and D investment in the 1990s. Also, R and D was closely linked to firm-level total factor productivity growth during that period. In fact, a 10 percentage point increase in the of debt-to-asset ratio lowered the firm-level total factor productivity growth rate by 0.72 percentage points for 1999-2001.

Dewenter, Hamao, and Hess use banking theory to try to understand the loan loss provisioning and write-off behavior of Japanese banks during Japan's economic slow growth period that began in 1992. They compare Japanese city and trust banks, and Japanese banks with banks from other countries that have similar banking systems. A major and surprising finding is that Japanese city banks differ from Japanese trust banks, but not from banks in other countries with similar banking systems. The Japanese banks are neither uniform nor unique.

Montgomery and Shimizutani examine the effectiveness of bank recapitalization policies in Japan. Based on a careful reading of the "business revitalization plan" submitted by banks requesting government funds, they identify four primary goals of the capital injection plan in Japan: 1) to increase the bank capital ratios; 2) to increase lending, in particular to small and medium enterprises, and avoid a "credit crunch"; 3) to increase write-offs of non-performing loans; and 4) to encourage restructuring. Using a panel of individual bank data, the authors estimate the effectiveness of the Japanese government policy of public fund injection in achieving the first two of these stated goals. They find that capital injections are more effective for international banks than for domestic banks. For international banks, receipt of injected capital seems to relax the constraint that capitalization makes on overall loan growth. Further, the receipt of injected capital strengthens the capital position of both international and regional banks. These results are based on ordinary least squares analysis and do not hold up once the authors control for possible endogeneity using an instrumental variables approach, though.

In sharp contrast to its fabulous postwar growth, the Japanese economy stagnated for a long time before World War II: prewar Japanese real GNP per worker remained at about 40 percent of that of the leader country, the United States, at least after 1885, with no capital deepening. Hayashi and Prescott identify as the main cause of the prewar stagnation a barrier that forced the number of persons employed in agriculture to be constant at about 14 million throughout the prewar period. A two-sector growth model shows that the barrier-induced sectoral misallocation of labor explains a virtual lack of capital deepening and the depressed output level. Were it not for the barrier, the model predicts that Japan's prewar GNP per worker would have been about 50 to 60 percent of the U.S. level, roughly where prewar Western Europe was. This higher output level comes about because an efficient use of labor otherwise locked up in agriculture raises the economy's overall production efficiency and sparks a rapid capital deepening.

Leigh investigates how monetary policy can help to avoid the liquidity trap. He first analyzes how the Bank of Japan conducted interest rate policy over the 1990s as the economy entered a deflationary slump. The Bank's implicit inflation target declined to about 1 percent in the 1990s from about 2.5 percent in the 1980s, he estimates. It seems that the problem arose because of a series of adverse shocks and not because of an extraordinary monetary policy mistake. Next, Leigh investigates whether an alternative monetary policy rule could have avoided the liquidity trap despite these shocks. He finds that targeting a higher rate of inflation of 2-3 percent would not have provided much protection against hitting the zero bound on nominal interest rates. Similarly, a policy of responding more aggressively to the inflation gap while keeping the low inflation target would have provided little improvement in economic performance. The economy still enters the trap under a nonlinear policy rule that commits the central bank to keeping interest rates at zero even after the economy begins to recover. However, Leigh finds that a rule that combined both a higher inflation target, of about 3 percent, and a more aggressive response to the inflation gap would have improved the economy's performance and avoided the zero bound.

The underlying causes of sharp declines in bank lending during recessions in large developed economies, as exemplified by the United States in the early 1990s and Japan in the late 1990s, are still being debated because of a lack of any convincing identification strategy of the supply side capital-lending relationship with lending demand. Watanabe attempts to construct a strong instrument for bank capital from empirical observation of the banks' behavioral changes in the past, and to estimate the impact of capital adequacy on the lending supply. He discusses the implications of prudential regulation and the ineffectiveness of a loose monetary policy based on the micro evidence presented.

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Globalization and Poverty

An NBER Conference on "Globalization and Poverty," organized by Research Associate Ann Harrison, University of California, Berkeley, took place on September 10-12. One of the biggest concerns of globalization's critics is its impact on the poor. The 15 chapters and comments in the volume that will result from this conference provide an economic perspective on how globalization affects poverty in developing countries. Although there have been many studies devoted to assessing the relationship between trade and inequality, this is the first comprehensive examination of the direct linkages between globalization and poverty.

The volume begins by considering the possible theoretical links between poverty reduction and globalization. This is followed by several cross-country studies that test for macroeconomic linkages using aggregate data. Many of the papers, as well as the discussions by Art Kraay and Xavier Sala-I-Martin, point out that greater global trade could reduce poverty by raising overall growth. The cross-country studies, while consistent with these claims, emphasize the necessity to use disaggregated data.

Each of the remaining papers uses microdata to estimate the impact of globalization on poverty within a particular country. Globalization matters to the poor because it affects the prices of goods that they consume and produce, as well as their wages and employment opportunities. This volume also investigates the indirect impact of globalization on the poor through its effect on risk, inequality, financial market deregulation, and aid flows to the poor. Several themes emerge across the different country studies.

First, the poor are more likely to share in the gains from globalization when there are complementary policies in place. The study on India suggests that globalization is more likely to benefit the poor if trade reforms are implemented in conjunction with labor market deregulation. In Zambia, poor farmers could only benefit from greater access to export markets if they also have access to credit, technical know-how, and other complementary inputs. The studies also point to the importance of social safety nets. In Mexico, if poor corn farmers did not receive income support from the government, their real incomes would have been halved during the 1990s. In Ethiopia, if food aid is not well targeted, globalization has little impact on the poor.

Second, the evidence suggests that trade reforms in a number of countries have contributed to reducing poverty. In Mexico, the poor in the most globalized regions have weathered the macroeconomic crises best. The study on Zambia suggests that poor consumers gain from falling prices for the goods they buy, while poor producers in exporting sectors benefit from trade reform through higher prices for their goods. In Colombia, the poor located in exporting sectors gained from trade reform. Unskilled workers in Poland have gained from its accession to the European Union, leading to broad income gains.

Third, both the cross-country and individual case studies suggest that financial crises are very costly to the poor. However, the evidence on Indonesia suggests that the poor recover surprisingly quickly. A study of financial deregulation across countries reinforces the need for complementary policies, such as the creation of reliable institutions and macroeconomic stabilization policies (including the use of flexible exchange rate regimes).

Since the evidence suggests that globalization creates winners as well as losers among the poor, the final study by Aisbett seeks to understand globalization's critics. Aisbett concludes that critiques of globalization arise because of concerns about short-term costs versus the longer-term gains from trade reform, as well as different interpretations regarding the evidence. This final chapter also points to the paucity of knowledge on the possible linkages between globalization and poverty reduction, which this volume seeks to address.

These papers and discussions will be published as Globalization and Poverty:

Donald Davis, NBER and Columbia University, "Trade and Poverty: Insights from Theory"
Discussant: Marc Melitz, NBER and Harvard University

Nava Ashraf, Harvard University; Margaret McMillan, Tufts University; and Alix Peterson-Zwane, University of California, Berkeley, "My Policies or Yours: Do OECD Agricultural Policies Affect Poverty in Developing Countries?"
Discussant: Mitali Das, Columbia University

William Easterly, New York University, "Globalization, Poverty, and All That: Factor Endowment versus Productivity Views"
Discussant: Aart Kraay, World Bank

Pinelopi K. Goldberg, NBER and Yale University, and Nina Pavcnik, NBER and Dartmouth College, "The Effects of the Colombian Trade Liberalization on Urban Poverty"
Discussant: Chang-Tai Hsieh, NBER and University of California, Berkeley

Gordon H. Hanson, NBER and University of California, San Diego, "Globalization and Labor Income in Mexico"
Discussant: Esther Duflo, NBER and MIT

Ethan Ligon, University of California, Berkeley, "Risk and the Evolution of Inequality in China in an Era of Globalization"
Discussant: Shang-Jin Wei, NBER and IMF

Petia Topalova, MIT, "Trade Liberalization, Poverty, and Inequality: Evidence from Indian Districts"
Discussant: Robin Burgess, NBER and London School of Economics

Jorge F. Balat and Guido G. Porto, World Bank, "Globalization and Complementary Policies: Poverty Impacts on Rural Zambia"
Discussant: Matthew Slaughter, NBER and Dartmouth College

James Levinsohn, NBER and University of Michigan, and Margaret McMillan, "Does Food Aid Harm the Poor? Household Evidence from Ethiopia"
Discussant: Rohini Pande, Yale University

James Levinsohn, "Globalization and the Returns to Speaking English in South Africa"
Discussant: Raquel Fernandez, NBER and New York University

Duncan Thomas, University of California, Los Angeles, "Globalization, Crises, and Households: Evidence from Indonesia"
Discussant: Donald Cox, Boston College

Chor-Ching Goh and Beata S. Javorcik, World Bank, "Trade Protection and Industry Wage Structure in Poland"
Discussant: Irene Brambilla, Yale University

Branko Milanovic and Lyn Squire, World Bank, "Do Pro-Openness Policy Reforms Increase Wage Inequality? Some Empirical Evidence"
Discussant: Douglas Irwin, NBER and Dartmouth College

M. Ayhan Kose and Eswar Prasad, IMF; Kenneth Rogoff, NBER and Harvard University; and Shang-Jin Wei, "Financial Globalization, Growth, and Volatility in Developing Countries"
Discussant: Susan Collins, NBER and Georgetown University

Emma Aisbett, University of California, Berkeley, "Why are the Critics so Convinced that Globalization is Bad for the Poor?"
Discussant: Xavier Sala-I-Martin, NBER and Columbia University

Davis provides the framework for the volume by identifying the theoretical channels through which changes in globalization could affect poverty and inequality. Focusing in particular on the impact of international trade, he reviews the standard implications of the popular factor models and sector specific models and shows that the effect of a trade reform on poverty and inequality is not clear. In particular, he shows that small changes in the assumptions used in these models reverse the standard prediction that labor intensive sectors of poor countries are the most likely to gain from trade reforms. He also explores the implications of economic geography models and models with heterogeneous agents for the relationship between trade, inequality, and poverty.

Developed countries heavily subsidize their agricultural sectors. The magnitude of these subsidies is striking, compared to both the size of the agricultural sector in these countries, and incomes in poor countries. Using a variety of empirical strategies, Ashraf, McMillan, and Peterson-Zwane seek to understand the impact of these subsidies on the poor in developing countries. They begin by using a cross-country regression framework, analyzing the relationship between per capita income and measures of rich-country subsidies to agriculture. The preliminary evidence suggests that OECD subsidies do affect incomes of the poor and that the sign of this effect depends on whether the country is a net importer or exporter of the agricultural product in question. The authors complement their cross-country analysis with a case study of Mexican corn farmers using data at the micro, individual farmer, and household level. The evidence from Mexico suggests that the income of the poorest corn farmers in Mexico from corn farming dropped substantially between 1991 and 2000. However, the total income of these corn farmers remained relatively stable. This is because the poorest corn farmers received substantial transfers. While some of these transfers were in the form of remittances, the majority of them came from the Mexican government through programs like PROGRESA and PROCAMPO.

Easterly notes that the textbook models of trade and factor flows say that globalization has three beneficial channels for unskilled workers in poor countries: 1) it gives them access to inflows of capital, which will raise the marginal product of labor and thus wages; 2) it gives them the opportunity to migrate to rich countries, where their wages will be higher; and 3) it gives them world market access for their goods, raising the wages of unskilled workers in labor abundant countries. These models assume that differences between rich and poor countries are caused by differences in factor endowments. Models in which productivity differences between countries drive trade and factor flows yield more ambiguous predictions. Unfortunately, productivity differences seem necessary to understand many, though not all, globalization and poverty episodes. The factor endowment predictions show how the North Atlantic economy achieved decreasing inequality between countries in the last five decades. They also help to explain the Great Migration of Europeans from the land-scarce Old World to the land-abundant New World in the late 19th and early 20th century, accompanied by the predicted movements in land rental/wage ratios. The factor endowment view of an earlier movement of Europeans to the colonies of the New World and southern Africa help us understand the origins of different levels of country inequality based on land/labor ratios. However, productivity differences appear to be an important facet of many globalization and poverty episodes. In the Old Globalization era, incomes of rich and poor countries diverged (as they did in other periods in which there was less globalization). In the New Globalization era, productivity differences are important for capturing: the very different performance of poor country regions in recent decades; the flow of all factors of production towards the rich countries; the higher skilled wages in rich than in poor countries; the low returns to physical and human capital in many poor countries; the failure of trade and capital inflows to reduce relative poverty within poor countries; and the persistence of regional "poverty traps," even within the free factor mobility and trade zone of the internal U.S. economy.

Goldberg and Pavcnik use the drastic tariff reductions during the Colombian trade liberalization of 1986 to 1994 to study the effect of trade openness on urban poverty in Colombia. Between 1986 and 1994-5, the urban poverty rate declined by approximately 10 percent, but then increased; by 1999 it had reached the same level as in the mid-1980s. While the increase in poverty between 1996 and 1999 often is attributed to the recession, the reasons behind its 1986-95 decline are less clear. Despite the chronological coincidence of the poverty reduction with the trade reforms over this period, the authors find no evidence of a link between poverty and tariff reductions operating through the labor income channel. Their results establish that poverty in urban areas is highly correlated with unemployment, employment in the informal sector, and non-compliance with minimum wages. The poverty rates among the employed also differ by industry, suggesting a potential role for industry affiliation in explaining poverty. However, there is no evidence that the trade reforms affected any of these variables in a significant way. Perhaps more surprisingly, most of the reduction in urban poverty between 1986 and 1994 is explained by "within" group changes in poverty, rather than by movements of people out of groups with high poverty rates - such as the "unemployed" or "informal sector workers" - and into groups with low poverty incidence (such as "employed"). However, it remains a possibility that trade liberalization has contributed to the poverty reduction through general equilibrium effects, and in particular through its potential role in lowering the prices of goods consumed primarily by the poor.

Hanson examines the change in the distribution of labor income across regions of Mexico during the country's decade of globalization in the 1990s. He focuses on men born in states with either high exposure to globalization or in states with little exposure to globalization, as measured by the share of foreign direct investment, imports, or export assembly in state GDP during the 1990s. Hanson finds that the distribution of labor income in high-exposure states shifted to the right relative to the distribution of income in low-exposure states. This change in regional relative incomes was primarily the result of a shift in mass in the income distribution of low-exposure states, from upper-middle income earners to lower income earners. On average, labor incomes in states with high exposure to globalization increased by 8-9 percent relative to low-exposure states.

Recent increases in urban income inequality in China are mirrored in increases in inequality in consumption expenditures. This connection between changes in the distribution of income and consumption expenditures could be entirely attributable to differences in preferences (in which case households' intertemporal marginal rates of substitution would all be equated after every history), or could be caused by imperfections in the markets for credit and insurance which ordinarily would serve to equate these intertemporal marginal rates of substitution. Ligon presumes that market imperfections drive changes in the distribution of expenditures, and he uses data on expenditures from repeated cross-sections of urban households in China to estimate a Markov transition function for shares of expenditures over the period 1985-2001. He then uses this estimated function to compute the welfare losses attributable to risk over this period, and to predict the future trajectory of inequality from 2001 through 2025.

Although there is a general presumption that trade liberalization results in higher GDP, much less is known about its effects on poverty and inequality. Topalova uses the sharp trade liberalization in India in 1991, to a large extent spurred by external factors, to measure the causal impact of trade liberalization on poverty and inequality in districts in India. Variation in pre-liberalization industrial composition across districts in India, and the variation in the degree of liberalization across industries, allow for a difference-in-difference approach. This strategy, which does not measure the first-order impact of trade liberalization common across all regions in India, establishes whether certain areas benefited more from, or bore a disproportionate share of, the burden of liberalization. In rural districts where industries more exposed to liberalization were concentrated, poverty incidence and depth increased as a result of trade liberalization, a setback of about 15 percent of India's progress in poverty reduction over the 1990s. The results are robust to pre-reform trends, convergence, and time-varying effects of initial district-specific characteristics. Inequality was unaffected in the sample of all Indian states in both urban and rural areas. The findings are related to the extremely limited mobility of factors across regions and industries in India.

During the 1990s, the Zambian government liberalized trade, improved macroeconomic policies, and implemented agricultural reforms, especially in maize and cotton. In their paper, Balat and Porto have two main objectives: to investigate some of the links between globalization, complementary policies, and poverty observed in Zambia during the 1990s, and to explore the poverty impacts of non-traditional export growth. They look at consumption and income effects separately. On the consumption side, they study the effects of the elimination of the consumer subsidies implied by the removal of the maize marketing board. They find that higher prices led to welfare losses and that complementary policies matter: the introduction of competition policies at the milling industry cushioned some of the impacts, but the restriction on maize imports by small-scale mills hurt consumers. On the income side, the authors estimate income gains from international trade. The gains are associated with market agriculture activities (such as growing cotton, tobacco, hybrid maize, groundnuts, and vegetables) and rural labor markets and wages. The authors find that by expanding trade opportunities, Zambian households would earn significantly higher income. Securing these higher levels of well-being requires complementary policies, like the provision of infrastructure, credit, and extension services.

It is sometimes claimed that food aid actually harms the poor. The logic behind this claim is that food aid depresses the price of food and the poor are producers of food. Levinsohn and McMillan investigate this claim using household-level data from Ethiopia - a primarily rural country that receives a tremendous amount of food aid per-capita. They find that food aid actually helps the poor, and that this is true in both urban and rural areas.

Levinsohn takes a novel approach to trying to disentangle the impact of globalization on wages by focusing on how the return to speaking English, the international language of commerce, changed as South Africa re-integrated with the global economy after 1993. He shows that the return to speaking English increased overall, and that within racial groups the return increased primarily for Whites but not for Blacks.

In recent years, several countries have experienced a massive and largely unanticipated collapse of the exchange rate. These collapses have been linked to the increased globalization of financial markets. The effects of these crises on the well being of the population are little understood. Using longitudinal household survey data from the Indonesia Family Life Survey (IFLS), Thomas examines the immediate and medium-term effects of the East Asian crisis on multiple dimensions of well being. In IFLS, the same households were interviewed a few months before the onset of the crisis, a year later, and again two years after that. This provides unique opportunities for measuring the magnitude and distribution of the effects of the crisis on the population. Thomas demonstrates that in the first year of the crisis, poverty rose by between 50 and 100 percent, real wages declined by around 40 percent, and household per capita consumption fell by around 15 percent. However, focusing exclusively on changes in real resources is complicated by the fact that measurement of prices in an environment of extremely volatile prices is not straightforward. Moreover, it misses important dimensions of response by households. These include changes in leisure (labor supply), changes in living arrangements (household size and thus per capita household resources), changes in assets, and changes in investments in human capital. These responses are not only quantitatively important but also highlight the resilience of families and households in the face of large unanticipated shocks because they draw on a wide array of mechanisms to respond to the changes in opportunities they face.

Goh and Javorcik examine the impact of Poland's trade liberalization, 1994-2001, on the industry wage structure. The data suggest that a worker's industry affiliation explains a substantial amount of variation in wages, ranging from 5 to 14 percent depending on the years considered. The results indicate that industry affiliation is an important channel through which trade liberalization affects worker earnings - a decrease in industry tariffs is associated with a higher industry wage premium. This result is robust to including year and industry fixed effects, controlling for exports, imports, real effective exchange rates, industry concentration, FDI stock, and capital accumulation. This finding is consistent with liberalization increasing competitive pressures, forcing firms to restructure and improve their productivity, which in turn translates into higher profits being shared with workers. In addition, the authors find that industries more exposed to import competition also have higher shares of unskilled labor. However, there is no significant effect of tariff reduction on industry-specific skill premium. Thus, the increased productivity from greater import competition appears to be applicable to all workers, regardless of their skill levels. In sum, there is no evidence of an erosion of wages of the unskilled (that is, "race to the bottom") from trade liberalization. Given that the poor in Poland are predominantly the unskilled (that is, those with little education), trade liberalization should be beneficial for the poor.

Prasad, Rogoff, Wei, and Kose provide a comprehensive assessment of empirical evidence on the impact of financial globalization on growth and volatility in developing countries. Their results suggest that it is difficult to establish a robust causal relationship between financial integration and economic growth. Furthermore, there is little evidence that developing countries have been consistently successful in using financial integration to stabilize fluctuations in consumption growth. However, the authors do find that financial globalization can be beneficial under the right circumstances. Empirically, good institutions and the quality of governance are crucial in helping developing countries to derive the benefits of globalization. Similarly, macroeconomic stability appears to be an important prerequisite for ensuring that financial globalization is beneficial for developing countries. Finally, countries that employ relatively flexible exchange rate regimes and succeed in maintaining fiscal discipline are more likely to enjoy the potential growth and stabilization benefits of financial globalization.

Milanovic and Squire ask: if there are pro-liberalization and pro-openness reforms, what will happen to wage inequality? They consider two types of wage inequality: between occupations (skills premium) and between industries. They use two large databases of wage inequality that have become available recently and a large database of reforms covering the 1975-2000 period. They find that trade reforms increase the skills premium but that the increase is smaller in rich than in poor countries. Trade reforms increase wage inequality between industries in rich countries and reduce it in poor countries.

Aisbett examines the values, beliefs, and facts that lead critics to the view that globalization is bad for the poor. She finds that critics of globalization tend to be concerned about non-monetary as well as monetary dimensions of poverty, and more concerned about the total number of poor than the incidence of poverty. In regard to inequality, critics tend to refer more to changes in absolute inequality, and income polarization, rather than to the inequality measures preferred by economists. It is particularly important to them that no group of poor people is made worse off by globalization. Finally, Aisbett argues that the perceived concentration of political and economic power that accompanies globalization causes many people to presume that globalization is bad for the poor, and the continued ambiguities in the empirical findings mean that this presumption can be supported readily with evidence.

These papers will be appear in an NBER Conference volume published by the University of Chicago Press. They also will be available on the NBER's website at "Books in Progress."

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Tax Policy and the Economy

The NBER's Nineteenth Annual Conference on Tax Policy and the Economy, organized by James M. Poterba of NBER and MIT, took place in Washington, DC on October 7. These papers were discussed:

Ann Witte, NBER and Wellesley College, "The Structure of Early Care and Education in the United States: Historical Evolution and International Comparisons"

Jonathan Gruber, NBER and MIT, "Tax Policy for Health Insurance"

James R. Hines, Jr., NBER and University of Michigan, "Do Tax Havens Flourish?"

Michelle Hanlon, University of Michigan, and Terry Shevlin, University of Washington, "Book-Tax Conformity for Corporate Income: An Introduction to the Issues"

Randall Morck, NBER and University of Alberta, "How to Eliminate Pyramidal Business Groups: The Double Taxation of Inter-corporate Dividends and other Incisive Uses of Tax Policy"

Witte notes that most European governments have universal, consolidated, education-based Early Childhood Education (ECE) programs that are available from early in the morning to late in the evening throughout the year. European ECE programs are uniformly of high quality, generally last at least three years, and are funded to serve all children. The U.S. ECE system is composed of three separate programs (Head Start, Pre-Kindergarten, and the child care voucher program) targeted to low-income children. With a few notable exceptions, U.S. ECE programs are funded to serve less than half of the eligible children. These programs developed quite separately; they have different goals, different funding sources, different administrations and policies, and generally last for an academic year or less. Pre-K and Head Start operate only 3 to 6 hours a day and are open only during the academic year. The average quality of U.S. ECE programs is generally much lower than the average quality of European ECE programs. Further, the quality of U.S. ECE programs varies widely even within local areas. Although the United States has greatly increased expenditures on ECE, U.S. governments pay only 40 percent of the costs of ECE, while European governments pay 70 percent to 90 percent of the costs of ECE. None of the major U.S. ECE programs simultaneously provides work supports for parents, child development opportunities for children, and preparation for school for low-income children. The evidence suggests that the U.S. ECE system is neither efficient nor equitable. Consolidation of funding and administration of current U.S. ECE programs could lower transaction costs substantially for parents and provide more stable care arrangements for children. Increased funding could improve existing programs, extend hours and months of operation, and make care available to all eligible families. Both the evaluation literature and the European experience suggest that such a consolidated, well-funded system could be successful in preparing poor children for school. Further, the benefits of such a program could well exceed the costs, because low-income children benefit most from stable, high-quality ECE. However, such a targeted program will have neither the positive peer group effects nor the social-integration benefits of universal ECE programs.

Gruber finds that, if the goal is to cover 3-8 million uninsured persons, expanding public insurance is a more efficient option than any tax policy that has been considered to date. Nonetheless, he suggests that it is critical to understand the strengths and weaknesses of alternative tax policy approaches. Several lessons for tax policy are clear from his analysis. First, and probably most important, targeting is key: tightly targeted tax policies dramatically outperform loosely targeted policies in terms of efficiency. This is important because targeting comes with political costs: it is much more politically expedient to allow a larger group of individuals to benefit from a policy than to restrict those benefits to a smaller low-income group. Yet widening the income range of tax policies comes at great cost in terms of their effectiveness. Second, one cannot straightforwardly compare two policies that cover very different numbers of uninsured, because the efficiency of any tax policy falls as its scope increases. Finally, for the efficiency of tax policy what matters is not only the targeting of benefits, in terms of the share of individuals who are uninsured, but also which individuals are covered. Providing coverage to very young and healthy individuals results in less insurance value per dollar of spending than does providing coverage to higher cost groups.

Hines notes that tax haven countries offer foreign investors low tax rates and other tax features designed to attract investment and thereby stimulate economic activity. Major tax havens have less than one percent of the world's population (outside the United States) and 2.3 percent of world GDP, but host 8.4 percent of foreign property, plant, and equipment; 13.4 percent of foreign sales; and 30 percent of the reported foreign incomes of American firms. Per capita real GDP in tax haven countries grew at an average annual rate of 3.3 percent between 1982 and 1999, which compares favorably to the world average of 1.4 percent. Tax haven governments appear to be adequately funded, with an average 25 percent ratio of government-to-GDP that exceeds the 20 percent ratio for the world as a whole, although the small populations and relative affluence of these countries normally would be associated with even larger governments. Whether the economic prosperity of tax haven countries comes at the expense of higher tax countries is unclear, but recent research suggests that tax haven activity stimulates investment in nearby high-tax countries.

Hanlon and Shevlin discuss the issues surrounding proposals to conform financial accounting income and taxable income. The two incomes diverged in the late 1990s with financial accounting income becoming increasingly greater than taxable income through the year 2000. While the cause of this divergence is not known for certain, many suspect that it is the result of earnings management for financial accounting and/or the tax sheltering of corporate income. The authors outline the potential costs and benefits of one of the proposed "fixes" to the divergence: the conforming of the two incomes into one measure. They review relevant research that sheds light on the issues surrounding conformity both in the United States and in other countries that have more closely aligned book and taxable incomes. The empirical literature reveals that it is unlikely that conforming the incomes will reduce the amount of tax sheltering by corporations, and that having only one measure of income will result in a loss of information to the capital markets.

Arguments for eliminating the double taxation of dividends apply only to dividends paid by corporations to individuals. The double (and multiple) taxation of dividends paid by one firm to another - inter-corporate dividends - was included explicitly in the 1930s as part of a package of tax and other policies aimed at eliminating U. S. pyramidal business groups. These structures remain the predominant form of corporate organization outside the United States. The first Roosevelt administration associated them with corporate governance problems, corporate tax avoidance, market power, and an objectionable concentration of economic power. Morck suggests that future tax reforms in the United States should keep in mind the original intent of Congress and the President regarding inter-corporate dividend taxation. Foreign governments may find the American experience a valuable lesson if they desire to eliminate their business groups.

These papers will be published by the MIT Press as Tax Policy and the Economy, Volume 19. They are also available at "Books in Progress" on the NBER's website.

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The Risks of Financial Institutions

The NBER held a Conference on the Risks of Financial Institutions in Vermont on October 22-23. Rene M. Stulz, NBER and Ohio State University, and Mark Carey, Federal Reserve Board of Governors, organized this program:

Franklin Allen, University of Pennsylvania, and Douglas M. Gale, New York University, "Systemic Risk and Regulation"
Discussant: Charles Calomiris, NBER and Columbia University

Andrew W. Lo, NBER and MIT; Mila Getmansky, University of Massachusetts, Amherst; and Nicholas Chan and Shane M. Haas, Alpha Simplex Group, "Systemic Risk and Hedge Funds"
Discussant: David Modest, Azimuth Trust Company, LLC

Stephen Schaefer, London Business School, and Loriana Pelizzon, University Degli Studi Di Padova, "Pillar 1 vs. Pillar 2 under Risk Management"
Discussant: Marc Saidenberg, Federal Reserve Bank of New York

Philippe Jorion, University of California, Irvine, "Bank Trading Risk and Systemic Risk"
Discussants: Paul Kupiec, FDIC, and Ken Abbott, Bank of America Securities

Jeremy Berkowitz, University of Houston, and James O'Brien, Federal Reserve Board of Governors, "Bank Trading Revenues, VaR, and Market Risk"
Discussants: Paul Kupiec and Ken Abbott

Darrell Duffie, NBER and Stanford University, and Chenyang Wang, Stanford University, "Leverage Management"
Discussant: Hayne Leland, University of California, Berkeley

Gary B. Gorton and Nicholas S. Souleles, NBER and University of Pennsylvania, "Special Purpose Vehicles and Securitization"
Discussant: Peter Tufano, Harvard University

Jan P Krahnen, Johann Wolfgang Goethe University, and Guenter Franke, University of Konstanz, "Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Loan Obligations"
Discussant: Patricia Jackson, Bank of England

Philip E. Strahan, NBER and Boston College; Evan Gatev, Boston College; and Til Schuermann, Federal Reserve Bank of New York, "How Do Banks Manage Liquidity Risk? Evidence from the Equity and Deposit Markets in the Fall of 1998?"
Discussant: Randall S. Kroszner, NBER and University of Chicago

Thorsten Beck and Asli Demirguc-Kunt, World Bank; and Ross Levine, NBER and University of Minnesota, "Bank Concentration and Fragility: Impact and Mechanics"
Discussant: Peter M. Garber, Deutsche Bank

Philipp Hartmann, European Central Bank; Stefan Straetmans, Maastricht University; and Casper de Vries, Erasmus University Rotterdam, "Banking System Stability: A Cross-Atlantic Perspective"
Discussant: Anthony Saunders, New York University

Torben Andersen, NBER and Northwestern University; Tim Bollerslev, NBER and Duke University; Peter Christoffersen, McGill University; and Francis X. Diebold, NBER and University of Pennsylvania, "Practical Volatility and Correlation Modeling for Financial Market Risk Management"
Discussant: Pedro Santa-Clara, NBER and University of California, Los Angeles

M. Hashem Pesaran, University of Cambridge; Til Schuermann; and Björn-Jakob Treutler, Mercer Oliver Wyman, "The Role of Industry, Geography, and Firm Heterogeneity in Credit Risk Diversification"
Discussant: Richard Cantor, Moody's Investors Service

Patrick de Fontnouvelle and Eric S. Rosengren, Federal Reserve of Boston; and John S. Jordan, Fitch Risk, "Implications of Alternative Operational Risk Modeling Techniques"
Discussant: Andrew Kuritzkes, Mercer Oliver Wyman

Historically, much of the banking regulation that was put in place was designed to reduce systemic risk. In many countries, capital regulation in the form of the Basel agreements is currently one of the most important measures to reduce systemic risk. In recent years there has been considerable growth in the transfer of credit risk across and between sectors of the financial system. In particular, there is evidence that risk has been transferred from the banking sector to the insurance sector. One argument is that this is desirable and simply reflects diversification opportunities. Another is that it represents regulatory arbitrage, and that the concentration of risk that may result from this could increase systemic risk. Allen and Gale show that both scenarios are possible depending on whether markets and contracts are complete or incomplete.

Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions - typically banks - that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds also are involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds.

As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. Lo, Getmansky, Chan, and Haas attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk, nonlinear factor models for hedge-fund and banking-sector indexes, and aggregate measures of volatility and distress based on regime-switching models. Their preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise.

Under the New Basel Accord, bank capital adequacy rules (Pillar 1) are substantially revised but the introduction of two new dimensions to the regulatory framework is, perhaps, of even greater significance. Pelizzon and Schaefer investigate the complementarity between Pillar 1 (risk-based capital requirements) and Pillar 2/PCA and, in particular, the role of closure rules with costly recapitalization when banks are able to manage their portfolios dynamically. Their approach considers the costs and the benefits of capital regulation in a way that accommodates the behavioral response of banks in terms of their portfolio strategy and capital structure, and further the extent to which capital rules are effective, that is, the extent to which banks can "cheat".

Jorion analyzes the risk of trading revenues of U.S. commercial banks. He collects quarterly data on trading revenues, broken down by business line, as well as the Value at Risk-based market risk charge. The overall picture from these preliminary results is that there is a fair amount of diversification both across and within banks across business lines. These low correlations do not corroborate concerns about systemic risk. Nor is there evidence that the post-1998 period has witnessed an increase in volatility of trading revenues.

Bank dealers play a central role in market-making in financial markets and are active traders in their own right. Recent literature has argued that trading activity and risk taking by banks and other financial institutions may contribute to market volatility and illiquidity. The literature further suggests that institutions' wide-spread adoption of Value at Risk (VaR) for risk management is one important source of destabilizing market behavior. O'Brien and Berkowitz study the market risks of seven large U.S. trading banks based on the banks' daily trading revenues and VaRs. Applying a linear factor model to bank trading revenues, with factors representing exchange rate, interest rate, equity, and credit markets, the authors consider the size and direction of risk exposures across markets as evidenced in the trading revenues and commonalities in exposures across the seven banks. They also test for non-linearity and time-variation in market exposures. Further, they consider the relationship between bank VaRs and market factor volatility.

An asset manager trades off the benefits of higher leverage against the costs of adjusting leverage in order to mitigate expected losses caused by insolvency. Duffie and Wang explicitly calculate optimal dynamic incentive-compatible leverage policies in simple versions of this problem.

Firms can finance themselves on- or off-balance sheet. Off-balance sheet financing involves transferring assets to "special purpose vehicles" (SPVs), following accounting and regulatory rules that circumscribe relations between the sponsoring firm and the SPVs. SPVs are carefully designed to avoid bankruptcy. If the firm's bankruptcy costs are high, off-balance sheet financing can be advantageous, especially for sponsoring firms that are risky. In a repeated SPV game, firms can "commit" to subsidize or "bail out" their SPVs when the SPV would otherwise not honor its debt commitments. Investors in SPVs know that, despite legal and accounting restrictions to the contrary, SPV sponsors can bail out their SPVs if there is the need. Gorton and Souleles find evidence consistent with these prediction using data on credit card securitizations.

Franke and Krahnen contribute to the economics of financial institutions' risk management by exploring how loan securitization affects their default risk, their systematic risk, and their stock prices. In a typical CDO transaction, a bank retains a very high proportion of the expected default losses, and transfers only the extreme losses to other market participants. This enables the bank to expand its loan business, thereby incurring more systematic risk. It also raises its beta. While the authors do not find a significant stock price effect around the announcement of a CDO issue, in line with the irrelevance proposition, they do find some cross-sectional variation related to issue characteristics.

Gatev, Schuermann, and Strahan report evidence from the equity market that unused loan commitments expose banks to systematic liquidity risk, especially during crises such as the one observed in the fall of 1998. They also find, however, that banks with higher levels of transactions deposits had lower risk during the 1998 crisis than other banks did. These banks experienced large inflows of funds just as they were needed - when liquidity demanded by firms taking down funds from commercial paper backup lines of credit peaked. The evidence suggests that combining loan commitments with deposits mitigates liquidity risk, and that this deposit-lending synergy is especially powerful during period of crises as nervous investors move funds into their banks.

Public policy debates and theoretical disputes motivate this paper's examination of the relationship between bank concentration and banking system fragility and the mechanisms underlying this relationship. Beck, Demirguc-Kunt, and Levine find no support for the view that concentration increases the fragility of banks. Rather, banking system concentration is associated with a lower probability that the country suffers a systemic banking crisis. In terms of policies, the authors find that regulations and institutions that facilitate competition in banking are associated with less - not more - banking system fragility, and including these policy indicators does not change the results on concentration. This suggests that concentration is a proxy for something else besides the competitive environment. Also, we do not find that official capital regulations, reserve requirements, or official prudential regulations lower crises probabilities. Finally, they present suggestive evidence that concentrated banking systems tend to have larger, better-diversified banks, which may help to explain the positive link between concentration and stability.

Hartmann, Straetmans, and de Vries derive indicators of the severity and structure of banking system risk from asymptotic interdependencies between banks. equity prices. They use new tools available from multivariate extreme value theory to estimate individual banks' exposure to each other (contagion risk) and to systematic risk. Moreover, by applying structural break tests to those measures, they study whether capital markets indicate changes in the importance of systemic risk over time. Using data for the United States and the euro area, the author also can compare banking system stability between the two largest economies in the world. Finally, they assess for Europe the relative importance of cross-border contagion risk as compared to domestic contagion risk.

What do academics have to offer market risk management practitioners in financial institutions? Current industry practice largely follows one of two extremely restrictive approaches: historical simulation or RiskMetrics. In contrast, Andersen, Bollerslev, Christoffersen, and Diebold favor flexible methods based on recent developments in financial econometrics, which are likely to produce more accurate assessments of market risk. Clearly, the demands of real-world risk management in financial institutions - in particular, real-time risk tracking in very high-dimensional situations - impose strict limits on model complexity. Hence, the authors stress parsimonious models that are easily estimated, and discuss a variety of practical approaches for high-dimensional covariance matrix modeling. They thus aim to stimulate dialog between the academic and practitioner communities, hopefully stimulating the development of improved market risk management technologies that draw on the best of both worlds.

In theory, the potential for credit risk diversification for banks could be substantial. Portfolios are large enough that idiosyncratic risk is diversified away leaving exposure to systematic risk. The potential for portfolio diversification is driven broadly by two characteristics: the degree to which systematic risk factors are correlated with each other and the degree of dependence individual firms have to the different types of risk factors. Pesaran, Schuermann, and Treutler propose a model for exploring these dimensions of credit risk diversification: across industry sectors and across different countries or regions. They find that full parameter heterogeneity matters a great deal for capturing tail behavior in credit loss distributions, and that this tail behavior is often not captured using standard value-at-risk (VaR) measures. Instead, the coherent risk measure, expected shortfall, is needed. Symmetric shocks to observable risk factors result in asymmetric loss outcomes, and this asymmetry is especially pronounced when full parameter heterogeneity is allowed for. While neither industry nor regional (geography) fixed effects are sufficient to capture this firm-level heterogeneity, controlling for industry effects seems to generate results which are closer to the fully unrestricted heterogeneous model.

Quantification of operational risk has received increased attention with the inclusion of an explicit capital charge for operational risk under the new Basel proposal. The proposal provides significant flexibility for banks to use internal models to estimate their operational risk, and the associated capital needed for unexpected losses. Most banks have used variants of value at risk models that estimate frequency, severity, and loss distributions. De Fontnouvelle, Rosengren, and Jordan examine the empirical regularities in operational loss data. Using data from six large internationally active banking institutions, they find that loss data by event types are quite similar across institutions. Furthermore, their results are consistent with economic capital numbers disclosed by some large banks, and also with the results of studies modeling losses using publicly available "external" loss data.

These papers will be published by the University of Chicago Press in an NBER Conference Volume. They will also be available at "Books in Progress" on the NBER's website.

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International Transmission and Comovement

An NBER-Universities Research Conference on International Transmission and Co-movement took place in Cambridge on December 10 and 11. Thirty-eight economists from 15 colleges and universities participated, along with representatives of the Federal Reserve System, the International Monetary Fund, and the European Central Bank. Marianne Baxter, NBER and Boston University, and Paul Bergin, University of California, Davis, organized this program:

M. Ayhan Kose, International Monetary Fund; Christopher Otrok, University of Virginia; and Charles H. Whiteman, University of Iowa, "Understanding the Evolution of World Business Cycles"
Discussant: Alejandro Justiniano, International Monetary Fund

Mihir A. Desai, NBER and Harvard University, and C. Fritz Foley, Harvard University, "The Comovement of Returns and Investment within the Multinational Firm" (NBER Working Paper No. 10785)
Discussant: Marco Del Negro, Federal Reserve Bank of Atlanta

Rebecca Hellerstein, Federal Reserve Bank of New York, "A Decomposition of the Sources of Incomplete Cross-border Transmission: The Case of Beer"
Discussant: Pinelopi Goldberg, NBER and Yale University

Giancarlo Corsetti, European University Institute; Luca Dedola, European Central Bank; and Sylvain Leduc, Federal Reserve Board, "International Risk-Sharing and the Transmission of Productivity Shocks"
Discussant: Michael Kouparitsas, Federal Reserve Bank of Chicago

Fabio Ghironi, Boston College, and Marc J. Melitz, Harvard University, "International Trade and Macroeconomics Dynamics with Heterogeneous Firms" (NBER Working Paper No. 10540)
Discussant: Michael Devereaux, University of British Columbia

Katheryn N. Russ, University of California, Davis, "The Endogeneity of the Exchange Rate as a Determinant of FDI: A Model of Money, Entry and Multinational Firms"
Discussant: Fabio Ghironi

Martin Boileau, University of Colorado, and Michel Normandin, HEC Montreal, "Dynamics of the Current Account and Interest Differentials"
Discussant: Camilo Tovar, Bank for International Settlements

Assaf Razin and Yona Rubenstein, Tel Aviv University, "Growth Effects of Exchange-Rate Regime and the Capital-Account Openness in a Crises-Prone World Market: A Nuanced View"
Discussant: Chetan Subramanian, University of Buffalo

Jinill Kim, Federal Reserve Board, and Sunghyun Henry Kim, Tufts University, "Welfare Effects of Tax Policy in Open Economies: Stabilization and Cooperation"
Discussant: Margarida Duarte, Federal Reserve Bank of Richmond

Luisa Lambertini, Boston College, "Fiscal Rules in a Monetary Union"
Discussant: Assaf Razin, NBER and Cornell University

Kose, Otrok, and Whiteman study the changes in world business cycles during 1960-2003. They use a Bayesian dynamic latent factor model to estimate common and country-specific components in the main macroeconomic aggregates (output, consumption, and investment) of the G-7 countries. Then they quantify the relative importance of the common and country components in explaining comovement in each observable aggregate over three distinct time periods: the Bretton Woods (BW) period (1960:1-1972:2); the period of common shocks (1972:3-1986:2); and the globalization period (1986:3-2003:4). The authors show how different types of shocks may have affected the nature of business cycle comovement over these three periods. Their results indicate that the common (G-7) factor explains a larger fraction of output, consumption, and investment volatility in the globalization period than it does in the BW period. The G-7 factor also accounts for a larger fraction of investment variation in the period of globalization than it does in the earlier periods. While there is a close association between the fluctuations in the G-7 factor and U.S. output growth for the full period, the G-7 factor becomes more influential in predicting the economic activity in the United States during the globalization period.

Desai and Foley present evidence on the comovement of returns and investment within U.S. multinational firms. These firms constitute significant fractions of economic output and investment in most large economies, suggesting that they could create significant economic linkages. Aggregate measures of rates of return and the investment rates of U.S. multinational firms located in different countries are highly correlated across countries. Firm-level regressions demonstrate that rates of return and investment rates of affiliates are highly correlated with the rates of return and investment of the affiliate's parent and other affiliates within the same parent system, controlling for country and industry factors. The evidence on these interrelationships, and the importance of multinationals to local economies, suggests that global firms may create an important channel for transmitting economic shocks. This evidence also sheds light on asset pricing puzzles related to the diversification benefits provided by multinational firms.

Hellerstein quantifies the sources of the incomplete transmission of shocks, such as exchange rate changes (that is, price inertia) using the example of the beer market. She considers two literatures on the sources of local-currency price stability with very different modeling approaches. The empirical trade literature on this topic, which includes Goldberg and Verboven (2001), attributes price inertia to a local-cost component and to firms' markup adjustments, but without modeling the role of each of these factors at each stage along a distribution chain. In the international finance literature, papers such as Burstein, Neves, and Rebelo (2003), Campa and Goldberg (2004), and Corsetti and Dedola (2004) attribute local-currency price stability to the share of local non-traded costs in final-goods prices, but do not allow for a role for markup adjustment by the firms that incur these costs, whether they be manufacturers or retailers. Hellerstein is the first to quantify the relative importance of these two factors for both manufacturers and retailers in the incomplete transmission of shocks to prices. She documents two basic facts about the transmission of shocks across borders. First, there is a nonlinear relationship between integration at the microeconomic level (proxied for by market share) and the transmission of shocks to prices. Second, a local component in manufacturers' costs explains a large part of the incomplete transmission, although markup adjustments by manufacturers and retailers play a nontrivial role.

A central puzzle in international finance is that real exchange rates are volatile and, in stark contrast to efficient risk sharing, negatively correlated with cross-country consumption ratios. Corsetti, Dedola, and Leduc show that a standard international business cycle model with incomplete asset markets augmented with distribution services can quantitatively account for these properties of real exchange rates. Distribution services, intensive in local inputs, drive a wedge between producer and consumer prices, thus lowering the impact of terms-of-trade changes on optimal agents' decisions. This reduces the price elasticity of tradables. Two very different patterns of the international transmission of positive technology shocks generate the observed degree of risk sharing: one associated with improving, the other with deteriorating terms of trade and real exchange rate. In both cases, large equilibrium swings in international relative prices magnify consumption risk because of country-specific shock, running counter to risk sharing. Suggestive evidence on the effect of productivity changes in U.S. manufacturing supports the first transmission pattern, questioning the presumption that terms-of-trade movements in response to supply shocks invariably foster international risk-pooling. Ghironi and Melitz develop a stochastic, general equilibrium, two-country model of trade and macroeconomic dynamics. Productivity differs across individual, monopolistically competitive firms in each country. Firms face a sunk entry cost in the domestic market and both fixed and per-unit export costs. Only the relatively more productive firms export. Exogenous shocks to aggregate productivity, and entry or trade costs, induce firms to enter and exit their domestic and export markets, thus altering the composition of consumption baskets across countries over time. In a world of flexible prices, this model generates endogenously persistent deviations from purchasing power parity that would not exist without this microeconomic structure with heterogeneous firms. The model provides an endogenous, microfounded explanation for a Harrod-Balassa-Samuelson effect in response to aggregate productivity differentials and deregulation. Finally, the model successfully matches several moments of U.S. and international business cycles.

Russ argues that when the exchange rate and projected sales in the host country are jointly determined by underlying macroeconomic variables, standard regressions of FDI flows on both exchange rate levels and volatility are subject to bias. Her results hinge on the interaction of macroeconomic uncertainty, a sunk cost, and heterogeneous productivity across firms. The results indicate that a multinational firm's response to increases in exchange rate volatility will differ depending on whether the volatility arises from shocks in the firm's native or host country. This is the first study to depart from the representative-firm framework in an analysis of direct investment behavior with money.

Boileau and Normandin study the relationship between the current account and interest rate differentials. To do so, they document the relationship in international data. Then they interpret that relationship from a two-country, dynamic, general equilibrium environment. Finally they confront the relationship predicted by the environment to the one observed in the data. They find that the environment correctly predicts that the current account is countercyclical; that the interest differential is procyclical; and that the current account is negatively correlated with current and future interest differentials, but positively correlated with past interest differentials.

It has been a remarkably difficult empirical task to identify clear-cut real effects of exchange-rate regimes on the open economy. Similarly, no definitive view emerges as to the aggregate effects of capital account liberalizations. Razin and Rubinstein hypothesize that a direct and an indirect effect of balance-of-payments policies, geared toward exchange rate regimes and capital account openness, together exert a confounding overall influence on output growth, in the presence of sudden-stop crises. The direct channel works through the trade and financial sectors, akin to the optimal currency area arguments. The indirect channel works through the probability of a sudden-stop crisis. The empirical analysis disentangles these conflicting effects and demonstrates that: the balance-of-payments policies significantly affect the probability of crises, and the crisis probability, in turn, negatively affects output growth; and, controlling for the crisis probability in the growth equation, the direct effect of balance-of-payments policies is large. Domestic price crises (that is, high inflation above a 20 percent threshold) affect growth only indirectly, through their positive effect on the probability of sudden-stop crises.

Kim and Kim study the optimal tax policy design problem using a two-country dynamic general equilibrium model with incomplete asset markets. They investigate the possibility of welfare-improving active, contingent tax policies (that is, tax rates responding to changes in productivity) on consumption, along with capital and labor income taxes. In contrast to the conventional wisdom on stabilization policies, procyclical factor income tax policy is optimal in the open economy. Procyclical tax policy generates efficiency gains by correcting market incompleteness. Optimal tax policy under cooperative equilibrium is similar to that under the Nash equilibrium and welfare gains from tax policy coordination are quite small.

Lambertini studies optimal fiscal policy rules in a monetary union where monetary policy is decided by an independent central bank. She considers a two-country model with trade in goods and assets, augmented with sticky prices, labor income taxes, and stochastic government consumption. Optimal fiscal policy is a simple, linear function of last-period change in debt and the underlying current shocks to the economy. It is optimal to finance an increase in government spending in part by running deficits and in part by raising income taxes, even though these are distortionary. Real public debt and taxes display random walk behavior. The optimal response of taxes to the change in debt is larger with the level of public debt, so that fiscal policy is tighter for countries with higher debt-to-GDP ratios. Optimal monetary policy is less aggressive in response to a government spending shock than the policy implied by an interest rate rule; the welfare cost of monetary policy delegation is high, about 0.29 percent of steady state consumption. Optimal fiscal policy delivers lower variability of the income tax rate than a deficit limit like the Stability and Growth Pact (SGP); however, the welfare cost of the SGP is small (between 0.001 and 0.036 percent of steady state consumption) as the SGP is unlikely to bind.

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