Knowledge that Transforms

It has become customary to look back with nostalgia at the golden age when the Bretton Woods system held sway, from the early 1950's to around 1970. It also seems to be the conventional wisdom, however, that the rules of Bretton Woods contributed little to the impressive performance of the world economy over that period-a performance characterized not merely by the fastest and most widely distributed growth in history, but also by notable stability, including near price stability except at the beginning and end of the period. The deterioration in the performance of the world economy since the early 1970's is viewed as a coincidence, or a response to common causes, rather than as a consequence of the breakdown of Bretton Woods. My purpose in selecting the title to this session was to induce critical scrutiny of these conventional attitudes. My own contribution to this task will start by describing what I conceive to have been the three essential rules of the Bretton Woods system. I shall proceed to examine the logic of those three rules in terms of recent contributions to the literature, in particular the emergent literature on policy coordination, and of recent historical experience.

A number of regulated industries, particularly in transportation and communications, have recently undertaken the transition from a regime of rigid price and entry controls to that of a more competitive market structure. While the different industries have experienced somewhat different fates, the responses to this transition do have certain common underlying characteristics. To start, demands for some form of temporary or continuing regulation during the transition to deregulation can be explained almost entirely as a response to the strength of the entry threat relative to the magnitude of sunk costs incurred by the affected parties in the previous regulatory regime. Where the obstacles to entry are low, the incumbent firms and labor ordinarily seek during the transition to permit them to recover some or all of their sunk costs. When the obstacles to entry are high, customers are likely to make similar demands for protective conditions designed to do the same, particularly when the customers' own sunk costs severely restrict their competitive options after deregulation. Pleas for protective conditions during the transition are widely regarded as introducing market imperfections that should be resisted in the name of regulatory reform. This view, however, naively equates the market results during the transition (when choices are constrained by the presence of sunk costs) to the results that would prevail in a long-run equilibrium where deregulated prices and quantities are established in the absence of most (or any) sunk costs. The regulatory problem during the transition is to define a set of residual (hopefully self-terminating) economic constraints that will satisfy the equity and other considerations created by the shortto medium-term continuation of some sunk costs without creating insurmountable obstacles to approaching an efficient competitive outcome in the long run. Any transition mechanism must thus come to grips with the essence of the transition problem from a political as well as an economic perspective: who is to bear the consequences of the overhang of sunk costs. Note that we are not making a generalized plea for the compensation of losers from deregulation, especially for windfall gains conferred by the regulatory process itself (see Kenneth Gordon, 1981). Rather, the transition problem is defined here to be a limited period in which participants in the regulatory game are permitted to amortize financial commitments made under the prior set of rules while other participants are constrained in their ability to exploit the presence of those sunk costs during the transition. Misunderstanding or failing to recognize this transition problem can pose substantial dangers: specifically, premature application of economic concepts that, while arguably valid in some future regime in which all sunk costs are amortized, decidedly do not account for the effect of these sunk costs on the marketplace in the short run. Misunderstandings of the transition problem may also encourage false conclusions about the eventual results of deregulation, that is, the long-run competitive equilibrium and industry structure that will emerge. As a consequence, policy recommendations designed to address the problems of the transition may tDiscussants: Robert Willig, Princeton University; Thomas Moore, Hoover Institution.

In this paper [the author presents] evidence that adds support to the economic approach to divorce [and shows] that the divorce rate is significantly and substantially affected by the earning ability of women in market work. Data [are] drawn from the U.S. farm sector. After a brief overview of the economic theory of divorce and its relevance to the farm sector data sources and regression specifications [are] discussed. (EXCERPT)

The Lucas critique of econometric policy evaluation (1976) argues that, to the extent econometric models do not capture the primitive parameters of tastes and technology, their coefficients can be expected to vary with changes in policy regimes. Several econometricians have undertaken empirical work that separates the parameters of tastes, technology, and policy, estimating models that are in principle immune from this critique. Exemplary contributors to this effort have been Thomas Sargent (1978) and Sargent and Lars Hansen (1980). The empirical work inspired by the Lucas critique has proceeded using representative agent models and aggregate data. The treatment of expectations and dynamic optimization has been careful, although at times necessarily limited by the analytical requirements of attaining closed-form solutions for dynamic programming problems under uncertainty. Potential problems due to have usually been ignored, although when preferences and technology are quadratic it appears that they can be disposed of quickly: assuming a representative firm is only a convenience, as the model admits a tidy theory of aggregation (Sargent, 1978, p. 1016). It is ironic that a paradigm that emphasizes the isolation of the primitive parameters of tastes and technology has led to empirical work that has ben conducted almost exclusively with aggregate data. (There are exceptions: T. MaCurdy, 1983; J. Biddle, 1984.) There are several difficulties with this development. First, the fact that representative agent models with exact can be constructed is unrelated to whether or not these models are adequate; we can also construct models in which agents' behavior is unaffected by the policy regime. To exclusively model and test one but not the other appears to be a misplacement of emphasis. Second, some of this work has proceeded using representative agents whose behavior cannot be aggregated exactly (see, M. Eichenbaum, Hansen, and Kenneth Singleton, 1984, for an example). There is a third and most fundamental objection to empirical work which seeks to avoid the Lucas critique, yet uses aggregate data. Whenever econometric policy evaluation is undertaken using models estimated with aggregate data, it is implicitly presumed that the aggregator function is structural with respect to the policy intervention in question. Formally, aggregator functions are no more structural than are within-regime, reducedform relations of endogenous to policy variables. As a modeling strategy, ignoring the sensitivity of aggregators to policy changes seems no more compelling than ignoring the dependence of expectations on the policy regime. This paper describes a very modest econometric model in which the effects of ignoring and of ignoring expectations, each within the context of several representative agent models, can be appreciated. Objective functions are quadratic and prices are disparate across agents; in these respects the model's assumptions are in the mainstream of Lucas and subsequent empirical work. The model is carefully contrived so that exact is always possible. This is not essential to the argument in any way, but it drastically reduces the number of circumstances to be examined in constructing numerical examples. The example pertains to neoclassical production, and in each case there are three distinct representative agents: one for production, one for factor demand, *Professor of Economics, Duke University, Durham, NC 27706. Financial support from NSF Grant SES8318778 and a Sloan Research Fellowship are gratefully acknowledged. A more detailed version of this paper is available on request from the author.