Although the ratio of gross fixed nonresidential investment to GNP has decreased very little since the late 1960's, the corresponding net investment ratio declined by nearly 40 percent between the second half of the l960's and the second half of the 1970's. Four-fifths of this decline was due to the increased ratio of depreciation to GNP and only one-fifth to the decreased ratio of gross investment to GNP. The increased ratio of depreciation to GNP was in turn due in equal amounts to the higher ratio of capital to GNP and to the higher rate of depreciation. Nearly half of the higher depreciation rate was due to the increased rate of depreciation of equipment and nearly half to the increased share of equipment in the capital stock.

The very poor performance of the stock market has been one of the major economic puzzles of the 1970's. The value of common stock has fallen significantly in relation to the price of final goods, the replacement value of the capital stock, and the value of pretax equity earnings. This fall in real share prices has raised the cost of capital to firms and has thereby reduced the incentive to invest in plant and equipment. Although no single factor is likely to have been responsible for this unusual performance of share prices, I believe that the sharp rise in during the past fifteen years has been one of the significant causes. Of course, should have no effect on real share values in an economy in which there are no taxes or other imperfections and in which portfolio investors correctly distinguish real and nominal magnitudes.' But the U.S. economy does have substantial taxes that are assessed on the basis of nominal (rather than real) capital income.2 An increase in the rate of raises the effective tax rate on equity earnings relative to the tax rate on other types of investment income. Individuals and financial institutions will therefore hold the existing stock of equity capital only at a lower real price. In Inflation and the Stock Market I presented a very simple model designed to capture the essential feature of this tax nonneutrality and its impact on share prices. The primary purpose of the analysis was to show how the overstatement of taxable profits caused by (because of historic cost depreciation and inventory accounting rules) could lead to lower real share prices even though reduced the real net-of-tax return on debt. This explanation stands in sharp contrast to the conventional view that lowers share prices because the (nominal) yield on debt rises. A second purpose of the analysis was to show how corporate stock could be a good hedge against inflation as long as the rate remained constant while being adversely affected by increases in the expected rate of inflation. And, finally, I wanted to indicate the importance of recognizing separately the roles of tax-exempt institutional investors and taxable individual investors. The analysis was definitely not intended to prove that must cause share prices to decline with existing U.S. tax rules. The model that I used is clearly far too simple in several ways to do more than illustrate a possible line of influence. The model assumes, among other things, that there are no retained earnings, no corporate debt finance, and no individual investment opportunities other than corporate stocks and government bonds.3 But the simplified model has the virtue of tractability and clarity that would be lost by adopting a more complex specification. In their comment, Irwin Friend and Joel Hasbrouck have presented a slightly different model of asset demand in an economy with taxes and inflation. I think that this alternative model is a useful complement to my own analysis. Moreover, as I shall explain in this reply, their model has the same implications as mine about the effect of on share prices. *President, National Bureau of Economic Research, and professor of economics, Harvard University. The study discussed in this note is part of the NBER Study of Capital Formation. The views expressed here are my own and not those of the NBER. 'Franco Modigliani and Richard Cohn have argued that many investors do not correctly evaluate either real profits or the relevant discount rate because they do not distinguish between real and nominal interest rates. 2This includes the use of historic cost depreciation, artificial inventory profits based on FIFO accounting, nominal interest income and expenses, and nominal capital gains. 3These features are included in a later model (see my 1980b article) designed to explain more of the complexities of the tax-inflation interaction.

The United States faces a rising future ratio of debt to GDP that, if allowed to continue, would have serious adverse consequences for the American economy. Fortunately, policy changes can increase the size of the future GDP and shrink the future budget deficits. Relatively small reductions in future annual deficits could reverse the increasing ratio of national debt to GDP. Those annual deficit reductions could be best achieved by slowing the growth of Social Security and Medicare and by raising revenue by limiting tax expenditures or increasing the tax on gasoline.

As recently as two years ago there was a widespread consensus among economists that fiscal policy is not useful as a countercyclical instrument. Now governments in Washington and around the world are developing massive fiscal stimulus packages, supported by a wide range of economists in universities, governments, and businesses. Why has this change occurred? What are the principles for designing a potentially useful fiscal stimulus? And what will happen if the current fiscal stimulus fails?

The explosion in the 21st century of terrorist activities by Islamic radicals in the United States, Europe and Asia requires reforming the institutions for domestic counterterrorism (CT) and new international relations among individual national CT organizations. This paper discusses the institutional reforms for CT in the United States, focusing particularly on the changes in the FBI. These changes are compared with the way that the British CT activities of the MI5 and MI6 have evolved in response to terrorism in Britain. The paper also discusses the reasons why there is strong cooperation among the CT activities of all the major governments and with the United States in particular, even when those governments do not agree about military cooperation or about the use of economic sanctions.

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