Knowledge that Transforms

I tackle a problem which I believe concerns all our disciplines; the problem of the legal processes involved in international trade regulation, and its various costs and benefits. Much of what I say could be applied to international processes, obligations, and institutions such as the GATT or OECD, but for reasons of time and space I will generally confine myself to the domestic U.S. laws and procedures concerning imports.' During the post-World War II period, there have been two parallel but clear trends in the system of United States regulation for imports. The first has been for the overall dramatic reduction in the level of tariffs since 1945, after the negotiation of the GATT, and the seven tariff and trade negotiating rounds under the auspices of GATT. The second trend has been a gradually accelerating recourse to measures for restraining imports other than normal tariffs, including measures entitled antidumping duties and This trend has particularly accelerated since 1962, and it is instructive to examine the major trade acts of 1962, 1974, and 1979 (the latter being the Trade Agreements Act of 1979, which implemented the results of the Tokyo Round Multilateral Trade Negotiations). The clear trend manifested in those statutes is towards a greater legalization or judicialization of the system. The 1974 act greatly reduced administrative discretion in the application of certain regulatory principles, particularly countervailing duties. It did this by imposing time limits, and in some cases embellishing the requirements for public hearings and other procedures to allow citizen access to the process. The 1979 act went even further in this regard, and also took some major steps in expanding the scope for judicial review of administrative actions. Consequently, as of this writing in 1983, the United States has a remarkably elaborate governmental system for the regulation of imports, including approximately a dozen different formal types of procedures or processes, many of which have explicit statutory procedural requirements calling for public hearings, judicial review, citizen complaint, and much reduced discretion for Executive Branch officials handling these matters. (See my 1977 book.) These include proceedings for escape clause, antidumping, countervailing duty, ? 337 unfair trade actions, ? 301 complaints against foreign government actions, etc. It is said that the U.S. legalistic system of regulating trade is costly, is itself a non-tariff barrier to trade, and lends itself to manipulative use by special domestic interests. Some of this may be true, but a systematic appraisal must examine at least three questions. 1) What are the real costs of the system? 2) What are the benefits of the system? 3) What alternatives to the system exist or are feasible, and what are their costs and benefits? I will therefore discuss those three questions, along with some policy and historical matters.

Ten years of floating exchange rates have not resulted in national policy autonomy. Indeed, in today's world, it seems scarcely conceivable that any exchange rate regime could enable countries to achieve their domestic objectives independently of what is going on elsewhere in the world; interdependence of national economies simply may not permit independence of national policies. Does this mean that policies directed in each country at getting the domestic situation right are to some extent hostage to the policy choice of others? If so, how do the constraints manifest themselves? Are these constraints made more or less onerous by the way the works? These questions are addressed by this paper; it would be too much to suggest that they are answered, or, indeed, are answerable in any definitive way. The early optimism that floating would free countries from balance of payments constraints and thereby enable them to direct policy, particularly monetary policy, to domestic objectives is perhaps understandable. The conditions over the period to the late 1960's had in many respects been particularly favorable to exchange rate stability. It would be natural if this led to the view that the few cases where exchange rate adjustment seemed called for would be better handled if exchange rates were left free to float, so that adjustment could take place relatively early and smoothly. But it would now seem that the typical applied economist or policymaker inherited from the period both a personal data base and a model that left him ill-equipped, in a number of ways, for what was to follow. First, few could have foreseen the extent to which countering inflation would need to become the overriding objective of policy. Second, supply-side shocks became bigger and more numerous. Third, the freedom and volume of financial flows has increased enormously. Fourth, the system that had been provided for much of the Bretton Woods period by the nth country role and anti-inflationary policies of the United States was lost, and no new anchor put in place. It could well be that the regime of floating rates that has been in operation over the last ten years has, at least in its broad features, been the only one that could have functioned in the prevailing conditions. If so, it may be that the regime has, at times, had an unwarrantedly bad press. The regime, and arguments put forward for its adoption a decade ago, should be judged not against some hypothetical ideal standard, but rather against what might otherwise have taken place. Ten years on, this judgement is not easy to make: what has not worked well is clearer than what is needed to make things work better.

With the growth of the literature on incentive compensation has come the belief by some that incentive pay may be less rigid than pay that is not designed to effect incentives. Some have gone so far as to argue that this may explain differences in unemployment rates across countries. it is shown that there is no direct link between incentives and wage rigidity. Many compensation schemes that provide incentives have the reverse effect: That is, they tend to make wages more rigid than would be the case were incentives not an issue atall. This paper explores the relationship between wage rigidity and the provision of incentives in a variety of circumstances.

Prize Lecture to the memory of Alfred Nobel, December 8, 1984

Two schools of macroeconomic thought compete today. The Keynesian school attempts to analyze each sector of the economy using the usual tools of optimizing models, but produces general equilibrium descriptions of a macroeconomy which are rarely Pareto efficient. For this reason, economists question the internal consistency of Keynesian models. In contrast, the neoclassical or .rational expectations school maintains consistency with the principles of perfect competition and flexible prices. In essence, the neoclassicists' macroeconomy behaves as an Arrow-Debreu general equilibrium. Once this is understood, we realize that the economy is Pareto efficient, though this does not preclude occasional ex post bad draws. Government policy can be expected to be either neutral or damaging. (In fairness, I am describing polar cases of the Keynesian and neoclassical view.) Nearly all economists are extraordinarily prejudiced in favor of models exhibiting rational behavior (as am I) and the last decade has seen an almost complete intellectual victory for the neoclassical school. Complete victory has been elusive for a single reason. In apparent ignorance of the intellectual arguments of the neoclassical school, the economy persists in behaving pretty much as the modern Keynesian models predict. As premier examples, neither the Great Depression nor the recent massive recession was (in my opinion) a Pareto-efficient equilibrium. The model I present below rigorously adheres to the rule that agents should follow rational principles. In this paper that rule means that agents equate marginal rates of substitution to relative prices. At the same time, I insert a single piece of imperfect information which prevents the formation of a complete Arrow-Debreu general equilibrium. The model predicts qualitative behavior of GNP and employment which is analogous to Keynesian predictions. Government spending is shown to increase GNP and economic welfare. The substantive results of the paper appear in the next three sections. Section I presents the role of imperfect information in the labor market and then goes on to solve for general equilibrium in the absence of government intervention. Section II examines the Keynesian-like behavior of this equilibrium. Section III examines the impact on GNP, aggregate labor supply, and welfare of balanced-budget government spending. The model produces four major results. 1) Aggregate spending and labor supply decisions are not simply the sum of individual decisions. The model identifies the logical error that Paul Samuelson has labeled the fallacy of composition. 2) Say's Law fails. A unit increase in aggregate supply produces a less than unit increase in demand for output. 3) An increase in government spending increases GNP and reduces unemployment. 4) An increase in government spending can generate a Pareto improvement in individual utility. The last section of the paper discusses some of the ways this model differs from the way we usually think about the economy. While the paper develops a particular model of aggregate demand, its real goal is to demonstrate a general principle: once the right set of mathematics is put together, it is easy to produce a model of the economy which is at once rational and Keynesian. In the specific setting I present, all the results fol*Department of Economics, University of Washington, Seattle, WA 98195. The first version of this paper was written while visiting at the Graduate School of Business, Stanford University. The final version was written while a member of the Finance Department, University of Pennsylvania. Shelly Lundberg deserves many thanks for extensive aid and partial absolution from any remaining errors. Stanley Fischer, Mark Flannery, Robert Solow, a number of other friends and colleagues, and two anonymous referees all contributed valuable constructive criticism for which I am most grateful.

High, in effect, is defined in this proposition in either of two ways. Most commonly, it has been taken to mean: high enough to warrant remedial intervention of some sort by the state.4 Recently, however, a growing minority of economists has urged that it be taken to mean instead: high enough to warrant intervention, provided the state can show that rates of return in excess of R1 reflect collusive behavior by the leading firms and not cost advantages which these firms have over their leading rivals.' Both meanings in turn reflect a third: high enough to imply a typical market price closer to PM in Figure lb than to Pc' where PM is the price that would prevail if the leading firms maximized collective, current-period profits and Pc is the price that would prevail if collective, current-period profits approximated zero.6 Proposition 1 rests on a large body of empirical work. Proposition 2, however, does not; nor does it rest on any theoretical analysis. Industrial economists simply have intuited that there is a correspondence between the R1R2 segment in Figure la and the PMP* segment in Figure lb. Are there substantive grounds for the intuition? I argue that there are not. The rates of return that lie along the R1R2 segment are competitive,