Knowledge that Transforms

Harry G. Johnson, The International Competitive Position of the United States and the Balance of Payments Prospect for 1968, The Review of Economics and Statistics, Vol. 46, No. 1 (Feb., 1964), pp. 14-32

H OUSING demand is a major factor in determining national income via private residential capital formation. Moreover, it fluctuates so widely, in many cases independently, in comparison with the demand for other consumer goods that it has been the focus of considerable attention on the part of economists. Yet there are markedly different opinions about the basic relationship of housing demand to changes in income or prices. As early as 1857, Engel made the first classic study of the relationship of family expenditures to income based on budget data; among other things, the percentages of housing to total expenditure were roughly estimated for three different socioeconomic groups. Later, Wright interpreted these estimates to mean that housing expenditure for lodging or rent takes a constant percentage of income at all levels of income. This is known as one of Engel's laws of consumption. However, Schwabe in 1868 presented empirical evidence that the percentage of income spent on rent falls as income rises.1 On the other hand, Marshall in his theoretical analysis, viewed housing as a means of obtaining social distinction as well as shelter, and said that where the condition of society is healthy, and there is no check to general prosperity, there seems always to be an elastic demand for house room, on account of both the real conveniences and the social distinction which it affords. 2 With these views Marshall seems to distinguish himself from his predecessors by stating that the demand for housing is rather elastic with respect to income. In recent years further controversy based on various empirical evidences has arisen. These dissimilar findings have led to radically different implications for important issues in the field of housing such as residential capital formation and the incidence of property taxes. Morton arrived at an income elasticity of demand of around 0.6 for the value of a house purchased, using cross-section data. Combining his estimate with the view that the property tax rate is constant over the different levels of property value, Morton concluded that the property tax was regressive.3 Winnick similarly derived an income elasticity of demand for the value of a house purchased of about 0.5, and noted a downward trend in per capita residential housing stock since 1900 (observed by Grebler, Blank, and Winnick) when real income was rising. Combining these with the assumption of a low price elasticity for housing, Winnick concluded that there had been a downward shift in consumer preferences for residential capital formation since around 1900. Recently Muth presented an intensive study 6 of stock demand elasticities for housing in which he rejected Morton's conclusion, stating that the income elasticity of demand for housing is about unity; i.e., more elastic than what Morton estimated. The price elasticity for housing stock estimated by Muth also exceeded unity, differing substantially from Winnick's contention. In view of high elasticities with respect to both income and price Muth cast doubt on

T HROUGH the wide range of Professor Harris' contributions to economics -in his writing, his teaching, his creative role as an editor, and his participation in governmentone characteristic stands dominant among the many. He has injected the vitality of fresh inquiry into every pursuit to which his lively interests have led him. His two most recent careers, at the Treasury and in California, continue to offer the scope and the challenge which he has met with such incredible versatility through the Harvard years. And it is in the spirit of one who has learned much from him not only in trying to find answers but also in formulating questions -that I would like to add a few more questions to the many that he has posed, and the many he has answered, on the processes of payments adjustment. How many of us have, I wonder, been taunted by some of these same questions as we puzzled along our separate ways toward a reconciliation between text and teacher in those ever-changing, ever-lasting Haberler-Harris courses on international trade? And how few of us, at least among my own pre-war vintage, could have thought that the major uses we would find for all of this would be in attempting to find acceptable norms for avoiding the anarchy of unimpeded freedom, rather than for resisting the strangulation of autarky. The leading countries of the non-communist world are now all learning again to live with convertible currencies for current account, and some for capital account, transactions. Most have for more than a decade been committed to an orderly codification of procedures for limiting the constraints that individual countries place upon the flows of goods from one to another. But the vast area that is still left without systematic and comprehensive attention from governments, and for which there is as yet no satisfactory theoretical formulation to use as a starting point under today's conditions, is that of long-term capital movements. Much has evolved, to be sure, concerning short-term capital movements. An alert sensitivity is developing -aided by the increasingly close and frequent consultations among governments and central banks that the jet age now permits -to the sometimes delicate inter-relations between flows of short-term funds and the effectiveness of monetary policy in any country. As a result, a very thorough reappraisal has been set off, in nearly every one of the leading countries, examining the potentialities for a changing mix among monetary, fiscal, and incomes policies potentialities that take account of the requirements of external as well as internal balance. Both in government policy and in underlying economic theory, however, long-term capital flows continue to be the object mainly of improvised rationalization for whatever has been going on. Apart from various efforts to multilateralize development aid, there has not as yet been a sustained effort to work toward a consensus on the role of movements of longterm capital in the adjustment process. There has been interest, primarily among some of the international organizations, in working toward a codification of procedures. But that does not go to the fundamental need for a reconsideration of the influence that movements of long-term capital may be able to exert as a balancing force. That need has now become compelling in a convertible world of gradually freer trade, where general commitments to high employment, continuing growth, price stability, and fixed exchange rates effectively rule out other patterns of adjustment that were familiar in the textbooks, if not always in the practices, of earlier years. Regardless of their merit, these postwar commitments are, in fact, constraints on the ready correction of surpluses or deficits in the overall external accounts of the various leading countries. Indeed, it is very largely on this account that a plausible case has been made for the likelihood that periods of imbalance may

considerable influence on estimated values of capital's average and marginal products, they do not greatly affect the estimated parameters of a production function. That is, estimated variations over time of the capital-output ratio are far more reliable than the estimated ratio for a given year if capital is measured by the perpetual inventory method. Since it is capital used rather than installed that is relevant in analysing production relations, some adjustment should be made for changes in the utilisation of capital. One possibility considered (Kr) was to adjust capital estimates (K) for changes in hours worked due to variations in holidays, overtime, short time, and the statutory working week. This allows for one form of excess capacity, the short running of machines, but not for the other, machines left completely idle. As an alternative (Ku), capital available was adjusted by the ratio of deflated electricity expenditure to horsepower installed. These estimates are shown in Table 2. The correlation between the three measures of capital shown in Table 2 is very high; between K and Ku, for example, it is 0.985. This suggests that in circumstances of overemployment (as there have been in New Zealand during the past decade) changes in excess capacity may be unimportant. The suggestion, however, is only tentative because the data on electricity consumption involve some inaccuracy in price deflation and do not allow for electricity used for heat and light.

In an important recent article,' Modigliani has renewed his analysis of the relationship between the real and monetary parts of the Keynesian system. One of Modigliani's major points in his latest article is that his famous 1944 model 2 embodied an error, for, in his opinion, it incorrectly specified the forms of the real aggregate consumption and investment demand functions.3 While we find much to agree with in this new model, we do not agree with him as to the fundamental source of error in the 1944 model. Consequently, we are in disagreement with some important aspects of the latest formulation and, as a result, with some of his more important conclusions. basic flaw in Modigliani's 1944 model is not the fact that the aggregate real spending functions were not homogeneous of degree zero with respect to prices.4 A quite different source of error was involved, and this error has been partly perpetuated in the 1963 model. While Modigliani's 1944 system contains a direct relationship between the price level and the money-wage rate,5 this relationship is omitted entirely from the monetary subset of equations. It is this relationship, however, which provides an essential link between the monetary and real sectors. In 1944, Modigliani claimed that the four equations which defined . . the system of monetary equilibrium were completely independent of the other equations in the system and formed a determinate subset.6 Consequently, Modigliani concluded that Since the money income is determined exclusively by the monetary part of the system, the price level depends only on the amount of and therefore a change in the money-wage rate could affect the price level only if it resulted in a change in the level of output.7 This surprising result is not only in conflict with Keynes' analysis of the effects of money wage changes,8 but it is also incompatible with Modigliani's own conclusion in a later section of that same 1944 paper. Towards the end of his 1944 article, Modigliani argued that a reduction in the moneywage rate will . . depress the interest rate, the money income, and money wages without affecting the real variables of the system, employment, output, real wage rate. 9 But how then can a change in the money-wage rate affect the rate of interest? If the money-wage rate change does not affect real output, then, by Modigliani's earlier assertion, it cannot affect the price level. If both the price level and the level of real output are unaffected, there should be no change in the transactions demand for cash balances and consequently no change in the rate of interest! Of course, a change in the moneywage rate does affect prices and output and, therefore, the rate of interest. Accordingly, Modigliani's belief that the monetary subset is independent of the money-wage rate must be in error. In his latest formulation, Modigliani explicitly introduces the price level variable into his demand for money equation in order to demonstrate that, given nominal money balances, changes in the money-wage rate will shift the entire money market function relating the rate of interest and the level of output.10 This implies that contrary to the 1944 model, at any given level of output, a decrease in the money-wage rate involves a reduction in prices and money incomes and therefore a decrease in the demand for transactions balances. Modigliani can now demonstrate that the moneywage rate has an impact on the demand for money equation, but, in his system, a change in the money* authors are associate professor of economics at the University of Pennsylvania and Lilly Faculty Fellow, University of Chicago, respectively. 'F. Modigliani, The Monetary Mechanism and Its Interaction With Real Phenomena, Review of Economics and Statistics, xxxxv (Feb., 1963), 79-101. 2 F. Modigliani, Liquidity Preference and the Theory of Interest and Econometrica, xiI (Jan., 1944), 4588; reprinted in Readings in Monetary Theory (New York: Blakiston, 1951), 186-239. All references are to the Readings in Monetary Theory reprint. 'F. Modigliani, The Monetary Mechanism and Its Interaction With Real Phenomena, 82. 'In fact, we shall argue that the real aggregate consumption function is incorrectly specified in the 1963 model. 'F. Modigliani, Liquidity Preference and the Theory of Interest and 188, equation 7. Ibid., 190. 7Ibid., 210. 'J. M. Keynes, General Theory of Employment, Interest, and Money, (New York: Harcourt Brace, 1936), Chap. 19. 'F. Modigliani, Liquidity Preference and the Theory of Interest and 220. 0F. Modigliani, The Monetary Mechanism and Its Interaction with Real Phenomena, 89-90.

T HREE years ago, Seymour Harris wrote that we must solve the problem as a condition for appropriate policies for growth, employment, aid, and defense; and several contributors to his book The Dollar in Crisis called for devaluation of the as the proper and indeed the only appropriate solution to the dollar problem. But economic growth in the postwar period has been universally high by historical standards. It has been especially high in the industrial countries of Continental Europe and Japan, both in comparison with the United States and in comparison with their own past. Real GNP in the six members of the European Economic Community, for example, rose 70 per cent between 1950 and 1960 -an average annual increase of no less than 512 per cent. Japan's growth was even higher. And even postwar United States growth was substantially higher than historical trends until the late fifties. In a year in which the international payments system is under close collective scrutiny by the major industrial countries, it is worth asking what role, if any, international monetary arrangements played in stimulating this growth. Dollar deficits may in fact have made a substantial contribution, and devaluation of the dollar, far from furthering free world growth, could well slow it significantly. Undoubtedly, no single factor can claim credit for postwar growth. The war-induced disturbance to old patterns of behavior and disillusionment with the prewar, static, competitive view of the world clearly fostered receptivity to rapid change in Europe and Japan. Psychological and economic momentum, gathered during the quick restoration of output to prewar levels, contributed to the sense that rapid growth was both possible and desirable. To these intangible factors were added powerful government incentives to business investment and extensive public investment. But surelv one imDortant element in the rapid postwar expansion was the presence of high export demand for European and Japanese goodsan export demand so high that additional output could always be sold profitably as soon as it became available. High demand was due in part to the continuing growth in total world demand. But it was also due to the possibility of substituting European and Japanese manufactured goods for American goods which had sometimes been the only goods available right after the war -in home markets, in third country markets, and even in the United States market. This substitution (in the context of growing markets) proceeded on a grand scale. The share of world exports of manufactures supplied by the six members of the European Economic Community, for example, rose steadily from 33 per cent in 1951 to 46 per cent in 1961 (Japan's rise was from 4 to 7 per cent), while the United States share fell sharply during the same period. United States imports of finished manufactures rose 250 per cent from 1950 to 1960, compared with a rise in United States industrial production of only 45 per cent. European and Japanese goods could be sold easily abroad because the currency devaluations of 1949 and other postwar currency changes made them cheap relative to goods, or very profitable to export at going market prices. Crude comparisons suggest the goods and services of Western Europe had declined in price by 24 per cent relative to the prices of American goods and services between 1938 and 1953.1 In 1950, the total purchasing power of the at official exchange rates was over 30 per cent higher in many European countries than it was in the United States.2 As might be expected, the of the in Europe was considerably greater for local services than for goods which move in international trade. Some products, notably produc-

Evsey D. Domar, Scott M. Eddie, Bruce H. Herrick, Paul M. Hohenberg, Michael D. Intriligator, Ichizo Miyamoto, Economic Growth and Productivity in the United States, Canada, United Kingdom, Germany and Japan in the Post-War Period, The Review of Economics and Statistics, Vol. 46, No. 1 (Feb., 1964), pp. 33-40