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Volume 10, Issue 2, April 2009

The Research Agenda: Marco Bassetto on the Quantitative Evaluation of Fiscal Policy Rules

Marco Bassetto is a Senior Economist in the Economic Research Department at the Federal Reserve Bank of Chicago. He is interested in political-economy models of fiscal policy and in applications of game theory to the analysis of macroeconomic policy more in general. This piece reflects the personal views of the author and not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Bassetto's RePEc/IDEAS entry.

1. Introduction

In 2009, the federal government is poised to run the biggest peacetime deficit in the history of the United States (both in absolute value and as a fraction of gross domestic product, or GDP). Current projections suggest that large deficits will persist in future years, considerably raising the debt/GDP ratio and putting additional strains on future public finances, which will soon also be challenged by the retirement of the baby boomers.

These developments are likely to rekindle debate about the desirability of imposing restrictions on government indebtedness. Constraints on deficit financing are the norm for state and local governments in the United States, and they are part of the European Stability and Growth Pact (SGP) to which eurozone countries have committed.

There is a large political-economy literature on government deficits and debt. On the theoretical side, most papers derive qualitative predictions from stylized models. On the empirical side, many papers have studied the consequences of different fiscal constraints on spending and debt (see, e.g., Poterba, 1994 and 1995, Bohn and Inman, 1996); these papers provide quantitative answers, but they do not contain a model that can be used for welfare considerations, or to extrapolate to fiscal institutions that have not been used in the past.

Few papers have attempted to bridge the gap, developing quantitative theoretical models that can be used to study the welfare properties of different fiscal restrictions. As an example, Krusell and Ríos-Rull (1999) have studied the dynamics of government redistribution under a balanced budget, as a function of the frequency with which government decisions are taken.

In this piece, I review some recent quantitative contributions that deal with fiscal deficits and debt, and I discuss open questions that warrant future consideration.

In the first set of papers, a balanced-budget restriction (BBR) is necessarily desirable, and the research question is whether public investment should be subject to the BBR in the same way as ordinary government expenses. The second set of papers abstracts from government investment, but introduces a cost of enacting a BBR, through the inability to smooth tax rates in response to shocks. It then becomes possible to discuss under what conditions a BBR actually improves welfare.

2. Does public investment deserve special treatment?

One of the main complaints about the original form of the European SGP concerned the lack of special provisions for public investment (see, e.g., Monti, 2005). Its reform in 2005 heeded these criticisms, and now "policies to foster research and development and innovation" are taken into account in evaluating whether a deficit is truly excessive (European Council on the Stability and Growth Pact, 2005, article 1).

Similarly, all U.S. states can borrow to pay for long-term capital projects. They follow what is known in public finance as the "golden rule," whereby a jurisdiction should balance its operating budget, but should be able to borrow to pay for capital improvements. This rule has a long tradition both in theory and actual policy, and is mostly justified on the grounds of "fairness": The operating budget is assumed to benefit current residents, who should thus bear its cost, while public improvements offer long-run benefits to future generations, which implies that it is fair to also ask them to share the burden by using debt financing.

How important was the 2005 reform of the SGP for restoring appropriate incentives to invest in public infrastructure? If a balanced-budget amendment were included in the U.S. Constitution, would public capital deserve special treatment? What other features of the environment are relevant in assessing the quantitative impact of different provisions? We look for the answers to these questions in a series of recent papers.

In Bassetto with Sargent (2006), we introduce the framework of analysis and apply it to the Unites States. In this research, we consider an economy populated by overlapping-generations of potentially mobile households, in which government spending is chosen period by period by current residents. In their decisions, voters only take into account their own present and future costs and benefits, while they neglect those that will accrue to other future residents (new people coming of age or new immigrants).

The government produces two types of public goods: One is durable, while the other is not. The environment is such that a BBR necessarily yields a Pareto-efficient choice for nondurable public goods: all households alive are assumed to benefit in the same way, and to also pay taxes in the same amount. A BBR forces current households to pay exactly for the services they get from the government, and yields correct incentives. The same does not happen for public investment, since current investment will have long-lasting benefits.

We analyze a constitutional restriction on government indebtedness that features two key parameters:
a. The fraction of government investment that can be excluded from the deficit count (e.g., 100% according to the golden rule) and
b. The maturity structure of debt, which measures how fast newly incurred debt has to be repaid.

Two relevant conflicts emerge in the determination of public investment: the first among current voters, who are heterogeneous by age and thus face different mortality and mobility profiles, and the second between current voters and future residents. With a growing population, the second effect always dominates under a pure BBR, leading to underinvestment: the current voters fully take into account the immediate cost, but they only partially internalize future benefits. Under further mild restrictions on the demographic structure and/or the maturity of debt, we obtain the intuitive result that allowing some issuance of debt alleviates the underinvestment.

In our quantitative calibration, we assume that the government is allowed to issue long-term debt that has to be repaid gradually over time through a sinking fund. This is a common practice among U.S. states. For this case, we establish the following results.

a. The golden rule, with 100% deficit financing of public capital, tends to perform very well. The precise amount of deficit financing that exactly yields an efficient outcome is not affected much by the demographic details.

b. When the constitutional restriction is far away from the optimum, demographics are important for the magnitude of the resulting distortions. This is not surprising, since demographics are what drives the economy away from Ricardian equivalence in our context.

c. When the borrowing limit treats public capital and nondurable public consumption in the same way, we find much bigger distortions at the state level than at the federal level. At the state level, people discount future costs and benefits because of mobility more than mortality: at most ages, the hazard of moving out of state is much higher than the hazard of death. By contrast, the hazard of moving out of the United States is negligible.

The quantitative results thus suggest that the current pattern of U.S. institutional restrictions is well matched to its theoretical benefits: the golden rule is practiced by the states, where benefits are likely to be large, but not at the federal level, where benefits would not be as prominent.

In Bassetto and Lepetyuk (2007), we apply the same model to European data. As expected, the costs of not including an investment exemption in the SGP turn out to be modest: European countries are about as far away from Ricardian equivalence as the U.S. federal government, with a somewhat higher hazard of emigration offsetting lower population growth.

More surprisingly, we find that the golden rule performs rather poorly in the context of the SGP, generating distortions from overinvestment that are about as big as those for underinvestment in the original version of the SGP, which treated operating and capital expenses symmetrically. This is because the SGP only counts interest payments against a country's deficit allowance, allowing indefinite rollover of debt principal. Thus, under the golden rule the additional taxes needed to pay for public investment would be shifted into the future much more than the benefits from the investment. Two possible solutions to this problem are as follows:
a. excluding less than 100% of investment from the deficit count (in our numerical results, about 50% turns out to be appropriate); and
b. excluding net, rather than gross,investment from the deficit count. By including depreciation in the deficit count, this strategy is equivalent to forcing a gradual repayment of the debt that is issued to finance public investment. The drawback of this strategy is that depreciation is difficult to measure, opening a new margin to skirt the rules.

In ongoing work (Bassetto, 2009), I extend the analysis to account for the possibility of endogenous mobility, as well as different tax bases. This extension of the research is particularly important to understand which rules are best suited for local communities, where the household location decision is much more likely to be affected by local amenities and taxes.

Starting from Tiebout (1956), there is a large literature in local public finance that considers how endogenous location affects voters' incentives. One of the central themes in this literature is capitalization: local amenities and debt are likely to be reflected in the property prices. The theoretical literature (see, e.g., the survey by Mieszkowski and Zodrow, 1989) has analyzed in detail the environments that are more or less conducive to capitalization. Most of these papers consider static environments, with a few considering overlapping-generations of households living for two periods; thus they are difficult to use for quantitative policy analysis. There is also a vast empirical literature that has tried to estimate the magnitude of capitalization.

I develop a dynamic model with long-lived agents, in which the parameters of the model can be more easily related to empirical counterparts, to deliver quantitative predictions about the effects of different policy rules on the efficiency of government spending.

When the tax base is income, endogenous mobility creates two opposing forces on the voters' incentive to provide public capital. First, a congestion externality is exacerbated: when additional public capital makes a location more attractive, more people move to that location, free-riding on the original investment and diluting its benefits for the original residents. Second, capitalization mitigates the externality: the increased demand for living in the location raises property prices, which benefits the original residents (assumed to own their house). Thus, it is important whether equilibrium adjustments mainly occur through quantity (population size) or through price.

Early quantitative results hint that the price adjustment will be insufficient to provide appropriate incentives for local public investment. An explicit rule that favors capital investment is thus called for. Alternatively, zoning restrictions are needed to drastically limit adjustment in population size.

3. Should we impose a BBR on the federal government?

Answering this question is one of the themes in recent work by Battaglini and Coate (2008a, 2008b) and Azzimonti, Battaglini, and Coate (2008). In their work, in each period the public sector can use its resources in two different ways: by providing public goods or by redistributing resources toward favored groups ("pork-barrel spending"). Public revenues come from a distortionary tax on labor, and the government has access to risk-free borrowing and lending, but cannot issue state-contingent debt. In each period, each group ("district") has one representative in the policy-making body ("Congress"), and a random coalition forms and makes a decision.

In this environment, debt is potentially beneficial for tax-smoothing considerations, such as in Barro (1979) and Aiyagari et al. (2002). However, access to debt is also a potential source of inefficiency, since the partisan nature of some policies introduces a deficit bias akin to what Alesina and Tabellini (1990) and Tabellini and Alesina (1990) describe. Specifically, in each period, the coalition in power has the opportunity to appropriate government funds and redistribute them to its own constituents. This is ex ante undesirable, since it involves raising revenues with distortionary taxes and rebating the proceeds to (a random group of) taxpayers. However, ex post, the transfers may be beneficial to the group in power at the expense of the others. Running deficits constrains future coalitions, which may redistribute government funds in ways that the current coalition finds undesirable.

Battaglini and Coate (2008a, 2008b) prove that the economy will necessarily alternate between two regimes:
a. "Responsible policy-making," when the marginal distortions from taxation are sufficiently high as to discourage diversion of public funds for redistributive purposes and
b. "Business as usual," when public resources are less scarce and the coalition in power engages in such targeted spending.

Responsible policy-making will prevail when the economy inherits a high level of public debt, or when it faces an adverse shock such as a high need for the general public good (e.g., during a war). When the adverse shock ends, the debt level gradually drifts lower, until it reaches a level at which business as usual restarts.

An important observation is that a BBR is a cure for one of the symptoms of inefficiency, but not for its source. While a deficit bias obviously disappears under a BBR, pork-barrel spending does not. In a calibrated example, Azzimonti, Battaglini, and Coate (2008) show that the prevalence of pork-barrel spending actually increases under a BBR, since the governing coalitions are no longer subject to the fiscal discipline imposed by servicing large amounts of debt. This insight potentially applies to many other environments, and serves as a warning that curing deficits simply by banning them may cause undesirable consequences unless we have a clear understanding of the political frictions that generate Pareto-dominated outcomes.

In ongoing work, Azzimonti, Battaglini, and Coate (2008) evaluate quantitatively the consequences of a balanced-budget amendment to the U.S. constitution. Their preliminary results show that the welfare consequences depend on the initial level of debt. When the government is not initially subject to a BBR and debt is at any of the values in the support of the associated ergodic distribution, introducing a BBR would never be desirable.

Azzimonti, Battaglini and Coate's calibration struggles to match the pattern of peacetime deficits, since the shock-absorbing role of government debt is minor in response to typical business-cycle shocks. This may be of concern because the cyclical behavior of spending is used to identify the magnitude of political distortions. Nonetheless, the match to the actual variability of spending and debt is quite good when the possibility of large shocks such as World War II is introduced, and their work represents an important step in developing a dynamic quantitative model of the costs of partisan policymaking.

4. Where should we go next?

The papers described in the previous sections are but one step in bringing quantitative economic modeling to the optimal design of fiscal institutions. Future work will have to develop in three dimensions:

a. Robustness

The previous analysis relies on specific political-economic frictions. To what extent do the implications generalize to other settings? As an example, let me briefly speculate on the robustness of the results about the golden rule.

It is straightforward to see that the rule would be much more beneficial if we assumed that operating budgets are subject to a deficit bias arising from partisan policymaking, while public investment is purely for the common good, as in Peletier, Dur, and Swank (1999), Azzimonti (2004), or Battaglini and Coate (2007). However, this assumption is at odds with the observation that "pork projects" are often capital items (e.g., the now infamous "bridge to nowhere").

Consider instead the following scenario, vaguely inspired by work of Rogoff and Sibert (1988), Rogoff (1990), and Besley and Smart (2007). Suppose that it takes time for voters to correctly assess the benefits of a long-term project (e.g., investment in renewable energy resources). Then, in the short run, it is difficult for the voters to distinguish the farsighted politicians, who are able to discern good projects, from the incompetent ones, who may pick projects more or less at random. This difficulty may bias policymaking to short-term projects, for which competence may be easier to signal to voters. Is this an important quantitative force? Only by developing models that are more detailed will we be able to gain confidence in the robustness of the institutional recommendations.

b. Analysis of other fiscal institutions

In this discussion, I have only addressed two specific questions. In practice, there are of course countless other dimensions of fiscal institutions worth considering. Taking again inspiration from current events, the stimulus package signed into law by President Obama on February 17 contains substantial transfers from the federal government to state governments. Moreover, federal matching is a standard feature for some expense items (such as interstate highways) but not in others (education). How large should a federal match be, and in what circumstances should it be granted? Are externalities from public goods quantitatively more important for this question, or is it more important to pay attention to insurance and discipline (see, e.g., Persson and Tabellini, 1996a and 1996b, or Sanguinetti and Tommasi, 2004)?

These questions are important not just for the United States, since transfers from the central government to regional/provincial governments are or have been prominent in a number of countries (e.g., Argentina, Brazil, or Italy).

c. Tax base

Should we rely more or less on property taxes, rather than income taxes, to finance government expenditures? Two provocative papers by Rangel (2005) and Conley and Rangel (2001) argue that land taxes (based on pure acreage, not value) would be very beneficial for intertemporal incentives. As we discuss in Bassetto (2009), the drawback of pure land taxes is that they would be unable to generate substantial revenues without dragging the value of the marginal land to zero, at which point the scheme unravels. Does this imply that we should move towards income or sales taxes? Or should we instead consider property taxes, which may have beneficial capitalization effects but distort capital accumulation?

d. Intergenerational accounting

In the works cited previously, what represents a deficit is clearly defined, and government debt captures well the intertemporal effects of fiscal policy. Yet Auerbach and Kotlikoff (along with various coauthors) have forcefully argued for intergenerational accounting as a more comprehensive and appropriate measure (see, e.g., Auerbach, Gokhale, and Kotlikoff, 1991 and 1994, and Kotlikoff, 1992).

In the context of distortionary taxation, a similar point is made formally in Bassetto and Kocherlakota (2004): When the government has the power to tax (or subsidize) past income, the same allocation can be supported by arbitrary paths for government debt (for an application to Social Security, see Grochulski and Kocherlakota, 2007). This is particularly an issue in models of "new dynamic public finance," where the fiscal distortions arise purely out of asymmetric information between the private sector and the fiscal authority. In these papers, the ability to tax past income is always present, and the deficit path may be correspondingly indeterminate.

Several papers have looked at the political-economy of intergenerational accounting, particularly from the perspective of social security (see, e.g., Cooley and Soares, 1996, Galasso, 1999, Song, Storesletten, and Zilibotti, 2007, and Bassetto, 2008). The introduction of a balanced-budget restriction would most likely interact with the considerations raised in these papers.

e. Timing of institutional reforms

Policy choices are endogenous in the work described previously, but institutional constraints are taken as given, and the goal of the research is to assess the welfare properties of imposing alternative restrictions on fiscal policy. A separate but important issue is when an institutional reform takes place, and how. In the case of U.S. states, the introduction of balanced-budget requirements dates back to the aftermath of the state defaults of the 1840s (see, e.g., Secrist, 1914). These constitutional reforms took place at a time when access to borrowing for states was severely disrupted; indeed, a renewed commitment to fiscal responsibility could be viewed as a way of restoring access to credit markets. This is but one example of a general pattern, whereby major fiscal reforms often follow a public finance crisis (for some other examples, see Sargent, 1983a and 1983b). The largely ineffective Gramm-Rudman-Hollings Act of 1985 could also be seen in this light - it was a preventative measure that was enacted out of concern for the consequences of the then-unprecedented deficits of the Reagan era.

While these considerations warrant a more systematic analysis, they suggest to me that now may be the perfect time for economists to engage in a debate over the fiscal institutions that will serve the United States for the next generation and beyond.

References

Aiyagari, Rao, Albert Marcet, Thomas J. Sargent, and Juha Seppälä, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, vol. 110(6), pp. 1220-1254.
Alesina, Alberto, and Guido Tabellini, 1990. "A Positive Theory of Fiscal Deficits and Government Debt," Review of Economic Studies, vol. 57(3), pp. 403-414.
Auerbach, Alan J., Jagadeesh Gokhale, and Laurence J. Kotlikoff, 1991. "Generational Accounts: a Meaningful Alternative to Deficit Accounts," in: "Tax Policy and the Economy," (D. Bradford, ed.), MIT Press, vol. 5, pp. 55-110.
Auerbach, Alan J., Jagadeesh Gokhale, and Laurence J. Kotlikoff, 1994. "Generational Accounting: A Meaningful Way to Evaluate Fiscal Policy," Journal of Economic Perspectives, vol. 8(1), pp. 73-94.
Azzimonti, Marina, 2004. "On the Dynamic Inefficiency of Governments," mimeo, University of Texas.
Azzimonti, Marina, Marco Battaglini, and Stephen Coate, 2008. "Analyzing the Case for a Balanced Budget Amendment to the U.S. Constitution," mimeo, University of Texas, Princeton University, and Cornell University.
Barro, Robert J., 1979. "On the Determination of the Public Debt," Journal of Political Economy, vol. 87(4), pp. 940-971.
Bassetto, Marco, 2008. "Political Economy of Taxation in an Overlapping-Generations Economy," Review of Economic Dynamics, vol. 11(1), pp. 18-43.
Bassetto, Marco, 2009. "Public Investment and Budget Rules for State vs. Local Governments," mimeo, Federal Reserve Bank of Chicago.
Bassetto, Marco, and Narayana Kocherlakota, 2004. "On the Irrelevance of Government Debt when Taxes are Distortionary," Journal of Monetary Economics, vol. 51(2), pp. 299-304.
Bassetto, Marco, and Vadym Lepetyuk, 2007. "Government Investment and the European Stability and Growth Pact," NBER Working Paper, n. 13200.
Bassetto, Marco, with Thomas J. Sargent, 2006. "Politics and Efficiency of Separating Capital and Ordinary Government Budgets," Quarterly Journal of Economics, vol. 121(4), pp. 1167-1210.
Battaglini, Marco, and Stephen Coate, 2007. "Inefficiency in Legislative Policy-Making: A Dynamic Analysis," American Economic Review, vol. 97(1), pp. 118-149.
Battaglini, Marco, and Stephen Coate, 2008a. "A Dynamic Theory of Public Spending, Taxation, and Debt," American Economic Review, vol. 98(1), pp. 201-236.
Battaglini, Marco, and Stephen Coate, 2008b. "Fiscal Policy over the Real Business Cycle: A Positive Theory," NBER Working Paper, n. 14047.
Besley, Timothy, and Michael Smart, 2007. "Fiscal Restraints and Voter Welfare," Journal of Public Economics, vol. 91(3-4), pp. 755-773.
Bohn, Henning, and Robert P. Inman, 1996. "Balanced-Budget Rules and Public Deficits: Evidence from the U.S. States," Carnegie-Rochester Conference Series on Public Policy, vol. 45, pp. 13-76.
Conley, John P., and Antonio Rangel, 2001. "Intergenerational Fiscal Constitutions: How to Protect Future Generations Using Land Taxes and Federalism," NBER Working Paper, n. 8394.
Cooley, Thomas F., and Jorge Soares, 1999. "A Positive Theory of Social Security Based on Reputation," Journal of Political Economy, vol. 107(1), pp. 135-160.
European Council on the Stability and Growth Pact, 2005. Council Regulation No. 1056/2005.
Galasso, Vincenzo, 1999. "The U.S. Social Security System: What Does Political Sustainability Imply?" Review of Economic Dynamics, vol. 2(3), pp. 698-730.
Grochulski, Borys, and Narayana R. Kocherlakota, 2007. "Nonseparable Preferences and Optimal Social Security Systems," Minnesota Economics Research Reports, n.1.
Kotlikoff, Laurence J., 1992. "Generational Accounting: Knowing who Pays, and when, for what we Spend," Macmillan, Free Press.
Krusell, Per, and José-Víctor Ríos-Rull, 1999. "On the Size of U.S. Government: Political Economy in the Neoclassical Growth Model," American Economic Review, vol. 89(5), pp. 1156-1181.
Mieszkowski, Peter, and George R. Zodrow, 1989. "Taxation and the Tiebout Model: The Differential Effects of Head Taxes, Taxes on Land Rents, and Property Taxes," Journal of Economic Literature, vol. 27(3), pp. 1098-1146.
Monti, Mario, 2005. "Toughen up the Reform Agenda and Make it Count," Financial Times, March 22, p. 17.
Peletier, Ben D., Robert A. J. Dur, and Otto H. Swank, 1999. "Voting on the Budget Deficit: Comment," American Economic Review, vol. 89(5), pp. 1377-1381.
Persson, Torsten, and Guido Tabellini, 1996. "Federal Fiscal Constitutions: Risk Sharing and Moral Hazard," Econometrica, vol. 64(3), pp. 623-646.
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Poterba, James M., 1994. "State Responses to Fiscal Crises: The Effects of Budgetary Institutions and Politics," Journal of Political Economy, vol. 102(4), pp. 799-821
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Rangel, Antonio, 2005. "How to Protect Future Generations Using Tax Base Restrictions," American Economic Review, vol. 95(1), pp. 314-346.
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EconomicDynamics Interviews Robert Barro on Rare Events

Robert Barro is the Paul M. Warburg Professor of Economics at Harvard University and a senior fellow of the Hoover Institution of Stanford University. He is currently interested in the interplay between religion and political economy and the impact of rare disasters on asset markets. Barro's RePEc/IDEAS entry.
EconomicDynamics: In your recent work, you have emphasized the impact of rare, but large, events on the economy, in particular interest rates and premia. Does the current crisis correspond to the large event you had in mind, and what does this imply for interest rates in the medium term?
Robert Barro: In our study, we defined a macroeconomic crisis as a decline (over one or more years) of per capita real GDP or consumption by 10% or more. We do not yet know whether the U.S. situation will fall into this range--the probability at present, given the stock-market performance, is around 25%. However, the current crisis is global, and several countries will likely end up in the depression range. Iceland and Russia, I think, are already there.

If the probability of disaster goes up--as it did last year after the spring--the real interest rate on safe assets, such as indexed U.S. Treasury bonds, should go down. The expected real return on risky assets, such as stocks, should go up (corresponding to a fall in stock prices). Thus, the equity premium goes up. Effects on nominal interest rates depend also on expectations of inflation. With low expected inflation over the short term, short-term nominal rates, such as on U.S. Treasury Bills, should become very low. Interest rates on medium term bonds should be higher than the short-term rates.

ED: The Great Moderation of the last two decades was characterized by dampened economic fluctuations and lower equity premia. Following your theory, can we interpret the latter as a consequence of the market putting lower probabilities on large events during this lull in fluctuations?
RB: A decrease in disaster probability would have the effect of lowering the equity premium. And the rise in price-earnings ratios up to 2007 is consistent with this reasoning. However, it's hard to determine equity premia on a high-frequency basis, such as annually, because stock returns are so volatile. Thus, even 20 years is not a long time for computing the expected rate of return on equity (based on the observed average return).
ED: Beyond the themes just discussed, where do you see you research agenda on disaster probabilities bringing you?
RB: As a general matter, I think the rare-disasters perspective is important for many aspects of finance and macroeconomics. As an example, Gabaix (2009) applies this framework to explaining ten puzzles in asset pricing. The approach is also promising for understanding puzzles related to exchange rates and interest rates. An example involves the carry trade--borrowing in a low-interest-rate currency such as the Yen and investing in a high-interest-rate currency. This strategy can appear to be profitable for a long time but then suffer greatly in a disaster situation. Thus, the streak of high returns is not really a puzzle in a setting that allows for the chance of rare disasters. This setting is analogous to the persistently high returns achieved for years by AIG (and perhaps also Harvard University's endowment).

At present, I am working with various co-authors on extensions of the previous research. One project estimates the form of the size distribution of disaster events (using a Pareto or power-law distribution, which has been used to explain patterns in city sizes, stock-market price movements, and many other phenomena). This method for pinning down the fat tail of the disaster distribution seems to lead to a better explanation of the equity premium. I am also working on the interplay between stock-market crashes and depressions to see how properties of the stock-market crash (What is the size of the crash? Is it accompanied by a financial crisis? Is it local or regional or global? Is it war related?) affects predictions for macroeconomic outcomes. I am also studying the nature of recoveries from macroeconomic disasters (notably wars and financial crises) and assessing the durations of depressions. Another extension, being pursued by my student Jose Ursua, will assess the Great Influenza Epidemic of 1918-20 as a possible source of the macroeconomic disaster that showed up in many countries, including the U.S. and Canada, with a trough around 1921. (By the way, President Wilson suffered from the flu in 1919 and this illness may have led to the harsh Versailles Treaty that likely caused WWII, and Max Weber--a key figure in the social science of religion--died of the flu in 1920.)

ED: Gabaix (2009) shows that a large range of puzzles can be explained by rare disasters. There have been (partially) successful attempts to address these puzzles with non-standard preferences such as hyperbolic discounting and loss aversion. You worked with Epstein-Zin preferences. Could the issue rather be framed in terms of preference formation? Would, for example, loss aversion reduce the need for disasters to explain data?
RB: In many contexts, shifting disaster probabilities have effects on asset prices that resemble those from shifting preferences--specifically, from changing degrees of risk aversion. Of course, I am myself inclined toward models in which preferences are stable and other factors move around. But the key matter is how to distinguish these approaches empirically. One difference is that changes in disaster probabilities have implications for the actual future course of disasters, whereas shifting preferences do not have these implications. The key challenge is to make these different predictions operational in a context where the frequency and size distributions of actual disasters are hard to pin down with short samples of data.
ED: In early work, you initiated a rich literature on the Ricardian Equivalence. After much additional theoretical and empirical work, do you think the Ricardian Equivalence holds? And if not, how and why?
RB: I think Ricardian Equivalence provides the right baseline in thinking about fiscal deficits. Then reasonable analyses have to specify precisely in which dimensions the results depart from this equivalence--and, thereby, have implications for interest rates, investment, and so on. Much of the research in this area, such as tax-smoothing ideas, look more like public finance, rather than macroeconomics, per se. Tax smoothing has important empirical predictions about how fiscal deficits should and do behave--for example, the prediction that deficits are large in wars and depressions. Political-economy elements, such as the strategic debt model (originally crafted to explain the large Reagan budget deficits), have also been important.

References

Barro, Robert J., 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec.
Barro, Robert J., 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October.
Barro, Robert J., 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Quarterly Journal of Economics, vol. 121 (3), pages 823-866.
Barro, Robert J., 2007. "Rare Disasters, Asset Prices, and Welfare Costs," NBER Working Paper 13690.
Barro, Robert J., and José F. Ursúa, 2008. "Macroeconomic Crises since 1870," NBER Working Paper 13940.
Barro, Robert J., and José F. Ursúa, 2009. "Stock-Market Crashes and Depressions," NBER Working Paper 14760.
Gabaix, Xavier, 2009. Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance, manuscript, New York University.

Society for Economic Dynamics: Letter from the President

Dear SED Members and Friends:

The developments reported in my last letter proceed apace. Richard Rogerson will be taking over as SED President at the end of the upcoming meetings in Istanbul. The handover at the RED has taken place with Gianluca Violante proving a very worthy successor to Narayana Kocherlakota, who continues to be active.

As you know the upcoming meetings will take place in Istanbul, Turkey July 2-4, 2009. They are hosted by Bahçeşhir University. Our co-chairs Jesús Fernández-Villaverde and Martin Schneider have put together a fantastic program including a great set of plenary speakers: Matt Jackson, Tim Kehoe and Chris Sims. Submissions were up this year by 16%, and there will be a record 429 papers in 12 parallel sessions. Our local organizers Nezih Guner, Refet Gürkaynak, Selo Imrohoroglu, Gökçe Kolasin and Kamil Yilmaz have lined up some great venues and activities. All the details can be found at http://www.economicdynamics.org/sed2009.htm. I look forward to seeing all of you in Istanbul.

For 2010, we plan to hold the meetings in Montreal. Montreal is a great city, and I expect we will put together our usual strong scientific program. Tentatively for 2011 we plan to go to Gent Belgium, and we will probably switch from alternating one year in North America, one year overseas to one year in North America with two years overseas.

Sadly I must report that because our Treasurer Ellen McGrattan avoided investing in mortgage backed securities, we are ineligible for TARP bailout funds.

Best Regards.

David Levine, President
Society for Economic Dynamics

Review of Economic Dynamics: Letter from the Co-ordinating Editor

Since January 1st, I have been serving as Coordinating Editor of the Review of Economic Dynamics. I feel very privileged to have this job. Tom Cooley, Gary Hansen and Narayana Kocherlakota, my predecessors, all did a phenomenal effort in rapidly getting the journal off the ground and in turning it into one of the success stories among Economics journals. On behalf of the Society, I thank Narayana Kocherlakota for the superb job he did in the last three and a half years as Coordinating Editor of RED.

Large part of the success of RED is due to the outstanding work of our Editorial Board, able to select high-quality papers among the many submissions we receive every year, and to turn very good papers into excellent ones through a constructive and fast refereeing process. I thank all the members of the Editorial Board for their dedication.

Over the next few months, we will have to replace some of our Editors and Associate Editors. I will keep using the same recipe of success of my predecessors, which is a mix of experience and new talent. Peter Ireland, who has served the RED for many years has already announced his resignation as Associate Editor, starting from July 1st, 2009. I wish to thank him for the outstanding service he has provided to the journal throughout his tenure. I am delighted to announce that Giorgio Primiceri (Northwestern) has accepted to take his place among our Associate Editors.

Now in its twelfth year of publications, RED is in excellent health and its reputation continues to grow well beyond members of the Society. The table below shows the ISI Impact Factor (one of the best known and most widely used indicator of a journal's quality) for RED and for a number of "competitors". The impact factor of a given journal for year t is calculated as the number times s articles published in year t-1 and t-2 were cited in all journals during year t.

ISI Impact Factor Comparison
20072006200520042003
Journal of Monetary Economics1.481.381.661.581.15
Review of Economic Dynamics0.970.840.480.630.60
J. of Money, Credit, and Banking0.951.160.980.920.84
International Economic Review0.921.031.280.820.84
J. of Econ. Dynamics and Control0.700.780.690.480.69
Macroeconomic Dynamics0.450.510.520.500.73

Two facts stand out. First, RED shows the highest gradient since 2003. Second, it has already caught up with IER and, JMBC, journals with a much longer history.

The review process at RED is fast, without compromising quality, which is what any serious academic journal should do. Last year we received over 200 submissions, and the average time until first decision was only 12 weeks. I believe this is one of the best records among Economics journals.

In sum, when you submit to RED, you are guaranteed a very quick turnaround, highly competent refereeing, and a chance of publishing on a journal whose reputation is growing at a fast pace.

At RED, we continue with the tradition of publishing special issues (approximately one every 1-2 years) representing the best research at the frontier of topics which are of special interest to members of the Society. Currently, we are planning two special issues.

The first one, "Cross-Sectional Facts for Macroeconomists," s being edited by Dirk Krueger, Fabrizio Perri, Luigi Pistaferri and me. Its aim is to document empirical regularities about cross-sectional distributions of income, hours, consumption and wealth for a number of countries. The underlying micro-data will be made available to the public in a user-friendly format. We hope that this issue will become a standard reference for all of us working with heterogeneous-agents models of the macroeconomy. The issue will be published in January 2010 and the evolution of the individual papers can be monitored in real time here.

The second special issue on "Sources of Business Cycle Fluctuations" is being edited by Stephanie Schmitt-Grohé and Martin Uríbe. Even though this project is at an earlier stage, nine papers have already been selected out of almost fifty high-quality submissions. These papers will be presented in a mini-conference within the SED meetings in Istanbul.

Finally, precisely with the SED meetings approaching, I want to echo the words Narayana Kocherlakota wrote in his letter in 2005, when he took over as Coordinating Editor: If you have a paper that is a good fit for the SED meetings (it needs not be a macro paper), and you are not sending it to a top general-interest journal, submit it to the Review of Economic Dynamics!

I look forward to receiving your submissions.

Gianluca Violante, Co-ordinating Editor
Review of Economic Dynamics

Review: Asset Pricing for Dynamic Economies

Asset Pricing for Dynamic Economies
by Sumru Altug and Pamela Labadie

This book offers an introduction into dynamic economics using asset pricing as the guiding theme. It is useful to graduate students of both macroeconomics and financial economics in that it offer in the same language and approach a unified treatment of discrete time dynamic economies. This book is self-contained: it offers the basic tools and goes through the basic models, in each case discussing various extension, empirical issues and suggesting exercises. As implied by the title, it starts with the basic asset pricing models APT, CAPM and CCAPM. It covers also production economies, non-separable utility, q-theory of investment, real business cycles, international asset markets, cash-in-advance, frictions, borrowing constraints and overlapping generations. The level of the treatment should make any graduate student comfortable with the material. Plenty of references are offered for further developments and readings. Instructors should also find plenty of inspiration for new approaches to teaching.

Asset Pricing for Dynamic Economies is published by Cambridge University Press.

Review: Economic Growth

Economic Growth: Theory and Numerical Solution Methods
by Alfonso Novales, Esther Fernández and Jesús Ruíz

Over the past years, a number of textbooks have been published that present computational methods for dynamic general equilibrum models. Typically, they would concentrate on business cycle models and only mention growth models in passing. The new book by Novales, Fernandez and Ruiz does the opposite: focus on numerical solution methods for growth models, with the addition of extensions on business cycles models (and growth theory, too).

The main sections cover the Neoclassical growth model, optimal growth in continuous and discrete time, endogenous growth and monetary economies. For each topic, the theory is introduced with various extensions, then numerical solution methods are discussed, along with some exercises. Note that Excel and Matlab codes are available on the web for various applications.

The book is self-contained and aimed at graduate students, but can also be used as a reference book. The unusually high cost for a graduate textbook (US$199) may discourage its widespread adoption, though, until the paperback version is published.

Economic Growth is published by Springer.

Impressum

The EconomicDynamics Newsletter is a free supplement to the Review of Economic Dynamics (RED). It is distributed through the EconomicDynamics mailing list and archived at http://www.EconomicDynamics.org/newsletter/. The responsible editors are Christian Zimmermann (RED associate editor) and Giovanni Luca Violante (RED coordinating editor).

The EconomicDynamics Newsletter is published twice a year in April and November.

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