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CONTEMPORARY ECONOMIC ISSUES Volume 5: and Finance

This is lEA conference volume no. 125 CONTEMPORARY ECONOMIC ISSUES

Congress Editor: Michael Bruno

Volume I REGIONAL EXPERIENCES AND SYSTEM REFORM Justin Yifu Lin (editor)

Volume 2 LABOUR, FOOD AND POVERTY Yair Mundlak (editor)

Volume 3 TRADE, PAYMENTS AND DEBT Daniel Cohen (editor)

Volume 4 ECONOMIC BEHAVIOUR AND DESIGN Murat Sertel (editor)

Volume 5 MACROECONOMICS AND FINANCE Holger C. Wolf (editor)

International Economic Association Series Standing Order ISBN 978-0-333-71242-9 (outside North America only)

You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above.

Customer Services Department, Macmillan Distribution Ltd Houndmills, Basingstoke, Hampshire R021 6XS, England Contemporary Economic Issues

Proceedings of the Eleventh World Congress of the International Economic Association, Thnis

Congress Editor: Michael Bruno

Volume 5 MACROECONOMICS AND FINANCE

Edited by

Holger C. Wolf

in association with the PALGRAVE MACMILLAN First published in Great Britain 1998 by MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 978-1-349-26074-4 ISBN 978-1-349-26072-0 (eBook) DOI 10.1007/978-1-349-26072-0

First published in the United States of America 1998 by ST. MARTIN'S PRESS, INC., Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y. 10010 ISBN 978-0-312-17759-1 Library of Congress Cataloging-in-Publication Data International Economic Association. World Congress (11th: 1995 : Tunis, Tunisia) Contemporary economic issues I congress editor Michael Bruno. p. cm. - (lEA conference volume; 122,123,125) Includes bibliographical references and index. Contents: - v. 2. Labour, food and poverty I edited by Yair Mundlak - v. 3. Trade, payments and debt I edited by Daniel Cohen - v. 5. Macroeconomics and finance I edited by Holger Wolf.

ISBN 978-0-312-17744-7 (cloth: v. 2). -ISBN 978-0-312-17760-7 (cloth v. 3). -ISBN 978-0-312-17759-l(cloth: v. 5)

I. Economics-Congresses. 2. Economic policy-Congresses. 3. Finance-Congresses. I. Bruno, Michael. II. Mundlak, Yair, 1927- . III. Cohen, Daniel, 1953- . IV.Wolf,HolgerC. V. Title. VI. Series: I.E.A. conference volume; no. 122, etc. HB21.165 1995 33O--dc21 95-4526 CIP © International Economic Association 1998 Softcover reprint of the hardcover 1st edition 1998 All rights reserved. No reproduction. copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London WI P 9HE. UNESCO Subvention 1994-951SHS/IDS/41 Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 1098765432 I 07 06 05 04 03 02 01 00 99 98 Contents

The International Economic Association vii Preface by Michael Bruno ix Abbreviations and Acronyms xiii List of Contributors xv

Introduction xvi Holger C. Wolf

1 Why Economists Do Not Make Discoveries

2 Policy Signalling in the Open Economy: A Re-examination 15 Allan Drazen

3 The Economics of Central Banking 37 Alex Cukierman

4 Modelling International Stock Return Cycles 83 Bernard Dumas

5 Financial Networks and Banking Policy 97 Patrick Honohan and Dimitri Vittas

6 Public Economics as Second-Best Analysis 118 Robin Boadway

7 On the Determinants of Economic Growth 138 Sergio Rebelo

8 The Continuum Approach to Unemployment Policy: An Overview 157 J. Michael Orszag and Dennis J. Snower

v vi Contents

9 Can the State Engage in Self-Control? A Survey of Old-Age Security 170 Salvador Valdes-Prieto The International Economic Association

A non-profit organization with purely scientific aims, the International Economic Association (lEA) was founded in 1950. It is a federation of some sixty national economic associations in all parts of the world. Its basic purpose is the development of economics as an intellectual discipline, recognizing a diversity of problems, systems and values in the world and taking note of methodological diversities. The lEA has, since its creation, sought to fulfill that purpose by promoting mutual understanding among economists through the organi­ zation of scientific meetings and common research programmes, and by means of publications on problems of fundamental as well as of current importance. Deriving from its long concern to assure profes­ sional contacts between East and West and North and South, the lEA pays special attention to issues of economics in systemic transition and in the course of development. During its nearly fifty years of ex­ istence, it has organized some hundred round-table conferences for specialists on topics ranging from fundamental theories to methods and tools of analysis and major problems of the present-day world. Partici­ pation in round tables is at the invitation of a specialist programme committee, but eleven triennial World Congresses have regularly at­ tracted the participation of individual economists from all over the world. The Association is governed by a Council, composed of representa­ tives of all member associations, and by a fifteen-member Executive Committee which is elected by the Council. The Executive Committee (1995-98) at the time of the Tunis Conference was:

President: Professor Jacques Dreze, Belgium Vice-President: Professor Anne Krueger, USA Treasurer: Professor Erich Streissler, Austria Past President: Professor Michael Bruno, (deceased 25 December 1996) Other Members: Professor Anthony B. Atkinson, UK Professor Vittorio Corbo, Chile Professor Karel Dyba, Czech Republic

VB Vlll The International Economic Association

Professor Jean-Michel Grandmont, France Professor Yujiro Hayami, Japan Professor Seppo Honkapohja, Finland Professor Valery Makarov, Russia Professor Luigi Pasinetti, Italy Professor Hans Werner Sinn, Germany Professor Rehman Sobhan, Bangladesh Professor Alan D. Woodland, Australia Advisers: Professor Kenneth J. Arrow, USA Academician Oleg T. Bogomolov, Russia Professor Mustapha Nabli, Tunisia Professor , India Professor Stefano Zamagni, Italy Secretary-General: Professor Jean-Paul Fitoussi, France General Editor: Professor Michael Kaser, UK

Sir was an active Adviser on the publication of lEA conference proceedings from 1954 until his final short illness in 1993. The Association has also been fortunate in having secured many outstanding economists to serve as President: (1950- 53), Howard S. Ellis (1953-56), (1956-59), E. A. G. Robinson (1959-62), Ugo Papi (1962-65), Paul A. Samuelson (1965- 68), (1968-71), (1971-74), Edmund Malinvaud (1974-77), (1977-80), Victor L. Urquidi (1980- 83), Kenneth J. Arrow (1983-86), Amartya Sen (1986-89). Anthony B. Atkinson (1989-92) and Michael Bruno (1992-95). The activities of the Association are mainly funded from the sub­ scriptions of members and grants from a number of organizations, in­ cluding continuing support from UNESCO, through the International Social Science Council. Preface Michael Bruno

The World Congress of the International Economic Association held in Tunis in December 1995 was the eleventh in a series that started in Rome in 1956 with the most recent one being held in Moscow in 1992. This Congress was marked by being the first to take place in Africa and the Middle East. This was reflected in having special sessions devoted to the Economic Development of Sub-Saharan Africa, Maghreb Economies and the Economics of the Middle East Peace Process, besides a wide array of topics in contemporary economics of development, trade, economic growth and general economic theory. Quoting from the opening speech by the President of Tunis, His Excellency Zine El Abidine Ben Ali:

Tunisia is very proud that your Association is holding its eleventh congress - the first such event to take place in Africa and the Mid­ dle East - on our soil. This will give you a good opportunity to concentrate your attention on the most recent developments in eco­ nomics and their role in strenthening development, as can be seen from the items on your agenda. The situation now prevailing in many countries, particularly those on our African continent, more than confirms the necessity of giving such issues an essential place in contemporary economic thinking.

Tunisia's impressive recent development effort, marking both a vig­ orous growth rate, low inflation, marked improvement in its social indicators, greater openness to international trade, as well as its ample cultural and historical treasures, made it a particularly interesting host country for our Association. It was a very lively Congress, with many high quality sessions, interspersed with several cultural and other events which introduced the broadly international group of attendees to the host country's institutions and culture. The Congress programme consisted of four plenary sessions (those by Professor Edmond Malinvaud, Professor Robert Putnam, the Austin Robinson Memorial lecture delivered by Professor Assar Lindbeck, as well as the Presidential Address). It had three panel sessions (chaired

ix x Preface by Professors U. Reinhardt, A. Tornell and S. Fischer), and 41 regular sessions. In these there were 43 invited papers and 278 contributed papers. The Congress was attended by about 700 participants coming from 68 different countries. The full list of the Programme Committee is as follows:

Bina Agarwal, University of Delhi, India , , USA Anthony Atkinson, Oxford University, UK David Audretsch, Wissenschaftszentrum Berlin, Germany Richard Baldwin, University of Wisconsin, USA , Delhi School of Economics, India David Begg, Birkbeck College, London, UK Fran<;ois Bourguinon, DELTA, Paris, France Daniel Cohen, CEPREMAP, Paris, France Vittorio Corbo, Catholic University of Chile, Santiago, Chile Partha Dasgupta, University of Cambridge, UK , MIT, Cambridge, Mass, USA Juan Dolado, CEMFI, Madrid, Spain Bernard Dumas, Groupe Hautes Etudes Commerciales, Jouy-en­ Josas, France Ibrahim Elbadawi, African Economic Research Consortium, Nairobi, Kenya Riccardo Faini, University of Brescia, Italy , The , Washington, USA Nancy Folbre, University of Massachusetts, USA Alberto Giovannini, Department of the Treasury, Rome, Italy Vittorio Grilli, Department of the Treasury, Rome, Italy Oliver Hart, , USA Sergiu Hart, Hebrew University of , Israel , Tel Aviv University, Israel Wontack Hong, Seoul National University, Korea Susan Horton, University of Toronto, Canada Peter Howitt, Universite des Sciences Sociales, Toulouse, France Ponciano Intal, Philippine Institute for Development Studies, Manila, Philippines Takatoshi Ito, NBER, Cambridge, Mass, USA Ravi Kanbur, The World Bank, Washington, USA Heinz Kurz, University of Graz, Austria Jean Jacques Laffont, Universite des Sciences Sociales, Toulouse, France

x Preface xi

Donald Lessard, MIT, Cambridge, Mass, USA Justin Yifu Lin, China Centre for Economic Research, Beijing, China Millard Long, The World Bank, Budapest, Hungary Karl-Goran Maler, Stockholm School of Economics, Sweden , London School of Economics, UK Yair Mundlak, University of Chicago, USA Mustapha Kamel Nabli, University of Tunis, Tunisia Benno Ndulu, African Economic Research Consortium, Nairobi, Kenya , Aoyama Gakuin University, Tokyo, Japan Siddiq Osmani, University of Ulster, Coleraine, UK Kirit Parikh, Indira Gandhi Institute of Development Research, Bombay, India Richard Portes, CEPR, London, UK Martin Ravaillon, The World Bank, Washington, USA Sergio Rebelo, University of Rochester, USA Uwe Reinhardt, Princeton University, USA Dani Rodrik, Columbia University, New York, USA Agnar Sandmo, Norwegian School of Economics, Bergen, Norway Murat Sertel, Bogazi~i University, Istanbul, Turkey Dennis Snower, Birkbeck College, London, UK Jan Svejnar, CERGE, Charles University, Prague, Czech Republic Peter Swan, University of New South Wales, Kensington NSW, Australia Peter Temin, MIT, Cambridge, Mass, USA Jacques Thisse, Ecole Nationale des Ponts et Chaussees, Paris, France Aaron Tornell, Harvard University, Cambridge, Mass., USA , Japan Development Bank, Tokyo, Japan Oliver Williamson, University of California at Berkeley, Cal., USA Charles Wyplosz, INSEAD, Fontainebleau, France Shahid Yusuf, The World Bank, Washington, USA Stefano Zamagni, University of Bologna, Italy Klaus Zimmerman, University of Munich, Germany

The proceedings of the Congress are being published in five vol­ umes under the general title Contemporary Economic Issues: Vol. 1: Regional Experiences and System Reform edited by Justin Yifu Lin Vol. 2: Labour, Food and Poverty edited by Yair Mundlak

xi xii Preface

Vol. 3: Trade, Payments and Debt edited by Daniel Cohen Vol. 4: Economic Behaviour and Design edited by Murat Sertel Vol. 5: Macroeconomics and Finance edited by Holger C. Wolf

I would like to record our gratitude to our Tunisian hosts who made this a highly successful conference. Besides thanking our illustrious host, His Excellency President Zine El Abidine Ben Ali, I would like to thank the local Organizing Committee, and first and foremost its Chairman, Mustapha Kamel Nabli, who bore the brunt of the respon­ sibility for the logistics and successful implementation of the Con­ gress. He was helped by Mongi Safra (Vice-Chairman), Mongi Azabou (Executive Secretary), Salah Maoui (Minister of Tourism), Salah Baccari (Minister of Culture) and the able Tunisian staff assisting them in their in their task. I would like to thank Francis Ghiles (Volume 1), Michael Kaser (Volume 2), John Butler (Volume 3), Maureen Hadfield (Volume 4) and Lesley Cook (Volume 5) for taking charge of the editorial prepa­ ration of these volumes. I am as always grateful to Michael Kaser, the General Editor of these series. Finally, I would like to record my thanks to Jean-Paul Fitoussi, the Secretary General of the International Eco­ nomic Association, not only for initiating the Congress in Tunis, but for his constant support with the preparations along the way. Abbreviations and Acronyms

AFP Administradora de Fondos de Pensiones (Pension Fund Management Company) ATM automatic teller machine BVG Swiss Federal Law on Occupational Pensions for Old Age, Survivorship, and Disability CAPM capital asset pricing model CB Central Bank CBI Central Bank independence CBR Central Bank of Russia CEPR Centre for Economic Policy Research CGE computable general equilibrium CIBCR Centre for Business Cycle Research COLA Cost of living adjustment CPI Consumer price index CREF College Equity Retirement Fund DB Defined on Base Earnings (pension plan) DC Defined on Contribution (pension plan) ECB European Central Bank EEC European Economic Community EMS European Monetary System EMU European Monetary Union ERISA Employment Retirement Income Security Act FLSIC Federal Savings and Loan Insurance Corporation FSE Former socialist economies GDP Gross domestic product GNP Gross national product IIF Indispensable institutional framework ILO International Labour Office IMF International Monetary Fund IRA Individual retirement account LDC Less developed countries MCPF Marginal cost of public funds NBER National Bureau of Economic Research NIC Newly industrializing countries OECD Organisation for Economic Co-operation and Development PBGC Pension Benefit Guarantee Corporation

Xlll XIV Abbreviations and Acronyms

PPP Purchasing power parity R&D Research and development RBC Real business cycles SEC Securities Exchange Commission SSA Social Security Administration TIAA Teachers Insurance Association of America VDA Variable deferred annuities List of Contributors

Professor R. Boadway, Department of Economics, Queen's Univer­ sity, Ottawa, Canada

Professor A. Cukierman, School of Economics, Tel-Aviv University, Israel; and Center, Tilberg University, Netherlands

Professor A. Drazen, Center for International Economics, University of Maryland, USA; and National Bureau for Economic Research, Washington, DC, USA

Professor B. Dumas, Haute Etudes Commercial, Paris, France; Duke University, Durham, North Carolina, USA; National Bureau of Econ­ omic Research, Washington, DC, USA; and Centre for Economic Policy Research, London, UK

Professor P. Honohan, Economic and Social Research Institute, Dublin, Ireland; and Centre for Economic Research, London, UK

Professor E. Malinvaud, Centre de Recherche en Economie et Statistique, and INSEE, France

Dr J. M. Orszag, Birkbeck College, University of London, UK

Professor S. Rebelo, Department of Economics, University of Rochester, New York, USA

Professor D. Snower, Birkbeck College, University of London, UK

Professor S. Valdes-Prieto, Instituto de Economia, Pontifica Universidad Cat6lica de Chile, Chile

Dr D. Vittas, World Bank, Washington, DC, USA

Professor H. C. Wolf, World Bank, National Bureau for Economic Research, Washington, DC; and New York University, USA

xv Introduction Holger C. Wolf WORLD BANK, USA

At first sight, this volume, which contains chapters covering topics ranging from economic methodology through central bank independ­ ence to pension systems, might be viewed as a pot-pourri of largely unrelated issues. Yet these chapters, written by leading researchers in their respective fields, dispel this notion, illustrating the ongoing merger process between hitherto quite separate economic sub-disciplines. On the macro level, separate chapters are devoted to the issues of credibility, policy choice in second-best environments, and the role of assumptions in economic modelling, yet the issues touched upon also play important roles in the chapters on the more narrowly-defined top­ ics, notably central bank independence, pension reform, and growth. On the micro level, the book demonstrates the increasing interlinkages between formerly distinct fields. To name but one example, where once public finance and growth economics were largely independent fields - some macro linkage exempted - the choice of pension structure is now viewed as one of the most important driving forces of savings, and hence longer term growth, and economic performance is recog­ nized as key to the solvency of many existing pension systems. Viewed as a whole, this volume provides a promising example of the benefits obtainable through cross-fertilization in economic research. The book begins with the invited lecture by Edmond Malinvaud, who asks why economists do not make discoveries as in the step ad­ vances occasionally seen in the natural sciences, but rather follow the social science model of gradual advances in knowledge. In Malinvaud's view, the two key obstacles that prevent discoveries are, first, the greater complexity of social (as compared with physical) systems that results from human interactions; and, second, the difficulty of conducting con­ trolled experiments, which prevents the empirical use of the economist's favourite qualifier - ceteris paribus. He pleads for restoration of some of the lustre to 'interpretative inferences' which were so dominant a part of the methodology in the great economic debates of the past. Of course, the decline of interpretative inferences, as Malinvaud acknowledges. was not entirely an accident. Mathematics has. and will

XVI Introduction xvii continue, to provide a valuable tool for assessing the validity of econ­ omic arguments. Looking forward, one wonders whether it is not the current focus on mathematical rigour rather than the methodology per se that underlies Malinvaud's argument. Viewed in this light, the out­ look does not appear altogether bleak. Since the mid-1980s, a number of authors - including Brian Arthur and Paul Krugman, taking their lead from physics and notably from theoretical biology, have begun to confront complexity head on. A paradigm shift towards viewing com­ plexity as a research challenge rather than as an irritant might yet be in the cards. We next turn from the philosophical to the practical; the credibility of policy is reviewed by Allan Drazen. The effect of current policies often depends on their secondary role as signals of future policies. This can lead to odd results; for example, a relaxation of controls on capital outflows may lead to an increase in capital inflows if that re­ laxation is seen as a positive signal about the future prospects for the -economy. Drazen argues that the conclusions drawn from this litera­ ture may be less than sturdy, as they rest on stringent simplifying as­ sumptions which direct attention away from relevant practical concerns - and here he touches on Malinvaud's theme. He quotes, as an exam­ ple, the apparent failure of 'tough' refusals to devalue to impress specu­ lators. The failure of tough talk is hard to rationalize in the standard signalling model: in this model the public, with diffuse views about the government's preference for a fixed exchange rate (or low infla­ tion) relative to some other target, (low employment, say) would inter­ pret a tough refusal to devalue as a signal about the government's preferences. This signal might be expected to deter speculation and imply a reduction in the expected likelihood of a devaluation. Drazen argues that the clash between theory and reality can be explained readily with a richer model that distinguishes between the credibility of the policy-maker and the policy itself by modelling credibility as a joint function of reputation and the economic environment, with mutual feed­ back. If tough action alters the perceived trade-off between low infla­ tion and unemployment through unexpectedly severe contraction, observers may revise upwards their view of the policy-makers' tough­ ness in facing a given constraint, but at the same time revise down­ wards their expectation that tough policies will be continued when faced with an altered trade-off. The issue of central bank independence is in part related to policy signalling. Although independence has been the exception rather than the rule, it has become fashionable because of the related views that, xviii Introduction

at least beyond a threshold, inflation retards growth, and that central bank independence reduces the likelihood of rapid inflation. Alex Cukierman argues that, even if it is present, the link between inflation and central bank independence does not imply that the adoption of legal independence will necessarily reduce inflation. On the one hand, legal and factual independence may differ, and on the other, the cen­ tral bank's trade-offs and preferences need to be considered. Cuckierman concludes with an interesting discussion of optimal contracts for cen­ tral bankers, emphasizing the distinction between goal and instrument independence. Stock market returns and business cycles exhibit a high correlation, with returns typically leading the cycle. While both the causes of business cycles and the determinants of aggregate stock returns have attracted much research interest, the bridging of the two fields is quite recent. In his paper, Bernard Dumas presents a critical overview of this emerging literature, emphasizing linked puzzles. In a first-best world, individu­ als receiving labour income in a particular country could hedge against shocks afflicting their home country by holding an internationally di­ versified portfolio. In consequence, one would expect to see consump­ tion growth being more highly correlated across countries than output growth, and one would expect individuals to hold a large - for most countries, a dominant - share of their investments in foreign assets. Neither prediction is supported by the facts. The linked puzzles admit two resolutions. First, it could be the case that various market distortions give rise to transaction costs leading to market segmentation, suggesting that large welfare gains could be ob­ tained through removal of these obstacles. However, a substantive body of empirical research suggests that transaction costs - at least of the conventional type - are too small to explain the puzzle fully. Hence the focus of research has shifted to asking whether the benefits of international diversification are indeed as large as previously suggested: if significant shares of consumption are devoted to non-tradables and actual utility functions are non-separable, then the benefits of diversi­ fication are substantially lower and, in consequence, the gap between actual and optimal portfolios would also be smaller. Empirical work also suggests that non-separability by itself cannot explain the home bias puzzle, however, the combination of transaction costs and non­ separabilities just might. In the wake of the banking system crises in the United States and Japan, the major Mexican crisis and the threat of banking system in­ stability in many of the transition economies, interest in banking crisis Introduction xix prevention has flourished. Patrick Honohan and Dimitri Vittas exam­ ine the minimal institutional requirements for etTective banking sys­ tems, stressing the need for three features: first, a central bank with the autonomy and ability to influence credit and interest conditions with a view towards maintaining stability; second, ownership and in­ centive structures allowing the banks to operate as profit centres; third, regulation aimed chiefly at safe and fair operation, without atTecting solvency or restricting enforceability of contracts. The three conditions are viewed as jointly necessary, with failure of a single one likely to reduce efficiency and stability significantly. Having delineated the final destination, Honohan and Vittas turn to the tricky question of improving existing systems, using a network approach and emphasizing three features. First, they note that network externalities typically render unregulated networks sub-optimal; for example, through self-justifying sunspot runs. The sub-optimality sug­ gests that optimal regulation can play an important role in sustaining the quality of the banking system. Alas, network systems are - because of nonlinear feedback - also characterized by high complexity, sug­ gesting that optimal rules need to be complex and to vary over time. In this trade-otT, the authors argue for a modest approach orientated towards ensuring risk-diversification and capital adequacy, but suggest that more complex regulatory objectives and policies, such as restric­ tions on branching, mergers, complex weighted capital adequacy measures and so on, while justifiable on conceptual grounds, are likely to run foul of the network complexity argument and, in consequence, are as likely to create new distortions as they are to eradicate old ones. Re­ dundancy provides the third important feature of networks - the failure of individual nodes in a network rarely has major systemic consequences. Intriguingly, the authors suggest that etTorts at strengthening these re­ dundancies - and thus limiting the systemic consequences of failure of individual nodes - has significant and largely unexplored potential. Robin Boadway takes up the theme of policy in a second-best world that is touched on in many of the other chapters. Multiple, potentially otTsetting, potentially reinforcing policy distortions complicate policy analysis and, in particular, the rating of alternatives. Boadway surveys the progress in the field of second-best analysis from its origins - sin­ gle consumers facing a single exogenous distortion - towards the re­ cent focus on a more complete understanding of the informational causes of failures of the second theorem of welfare economics, and their lim­ iting impact on policy. He presents two interesting applications which illustrate the limits xx Introduction of redistributive policy and the impact of time inconsistency problems. In both cases, he emphasizes that in the presence of informational asymmetries, second-best policies might include measures that at first sight might seem surprising but which derive their power precisely through their effect on the informational asymmetry. In the case of redistribution policies, these include minimum wages and workfare; in the case of time inconsistency problems, tax holidays, up-front invest­ ment incentives, and social insurance. What sets apart countries such as the United States, doubling in­ come per capita every thirty-five years, from the likes of Singapore, achieving a doubling every nine years, and Guyana, standing still? The years since the mid-1980s have witnessed a strong resurgence of inter­ est in the causes of growth differentials. Sergio Rebelo begins his sur­ vey of the field with a review of the shift from the exogenous productivity growth models of the 1950s to recent work focusing on externalities to investment, R&D activity and human capital accumulation. He next turns to the potential role of policy. Conceptually, policy matters to the degree that it influences either investment in human and physical capital, or the rate of GDP growth. The above-average growth achieved by the miracle economies promises to throw some light on the scope for raising growth along these lines, and has indeed been the focus of a lively empirical debate during the 1990s; the tentative conclusion is that the additional growth can largely be attributed to above-average rates of investment, rather than fast productivity growth. However, Rebelo suggests that not too much should be read into these experiences: good as well as bad policies tend to be bunched, making it inherently difficult to detect the key ingredients of the parsimonious 'recipe' thought responsible for the growth of the miracle economies. Rebelo concludes by looking at the nexus between politics, the so­ cial system and growth; this is an area increasingly at the core of research into cross-national growth differences. Progress has a cost: as production modes change, skills become obsolete, employment in old sectors contracts, and new sectors expand. Fast growth raises the speed of this structural change, thus creating significant losers alongside the winners, and consequently political opposition to reform. Rebelo argues, intriguingly, that it is efficient compensation to the losers which sets apart the economies able to sustain rapid growth for prolonged periods. Reducing long-term unemployment has become a pressing problem in many Europeans economies. Michael Orszag and Dennis Snower review the literature on the topic, focusing in particular on policies aimed at reducing the employer's cost of hiring the long-term unemployed. Introduction xxi

While actual policies vary, Orszag and Snower suggest that they can be condensed into a generic voucher scheme, with two key dynamic properties: the dependence of the voucher on unemployment duration and on the subsequent length of job tenure. Arguing that the common practice of treating the long-term unemployed as a readily identifiable group may be misleading, they place their analysis in the context of a model with hiring and firing rates varying along a continuum. Within this setup they derive the optimal voucher structures which minimize the level of unemployment subject to a government budget constraint and taking account of the voucher savings due to reduced unemploy­ ment. Using this framework, Orszag and Snower demonstrate that the optimal design of voucher systems is a far from trivial exercise, likely to be subject to important non-linearities. The structure of public pension systems has assumed a central role both in mature systems (in which many 'pay as you go' systems ap­ pear to be heading inexorably towards insolvency), and in developing economies, many of which are searching for ways to enhance savings. Salvador Valdes-Prieto reviews the recent literature in this burgeoning field, aiming to explain observed pension systems with significant gov­ ernment involvement and, very commonly, a strong mandatory element. His results are intriguing. Beginning with efficiency arguments, he establishes that adverse selection, moral hazard and concerns about improvidence indeed provide an efficiency argument for government involvement. However, the implied optimal pension schemes would entail quite small contributions, equally small benefits and a strict pro­ portionality between contributions and benefits - none of which de­ scribe currently existing pension schemes. He thus turns to another potential motive for government intervention: that of equity, and specifically, income transfers to the poorest among the old. Again, how­ ever, the evidence does not support the motive; by and large, current pension systems do not redistribute significantly towards the least well­ off. Rather, Valdes-Prieto concludes, the motivation for current pen­ sion systems might have to be sought in intergenerational redistribution - from future to current generations. This book provides authoritative assessments of topical issues by leading observers. They move the focus of attention, and challenge received wisdom.