The average U.S. consumer now enjoys a larger and higher-quality home than ever before. In 2001, the average home was 1,693 square feet, while in 1960 it was less than 1,200 square feet. In 2001, 58 percent of homes had three or more bedrooms, and 57 percent had 1.5 or more bathrooms. Compare that with 1970, when fewer than half of homes had three or more bedrooms and only 30 percent had 1.5 or more bathrooms. Housing amenities have also improved. In 2001, 76 percent of homes had a washing machine, 73 percent had a dryer, 56 percent had a dishwasher, and 44 percent had a kitchen sink garbage disposal; 58 percent of homes had a garage, and 80 percent had an outdoor deck or patio. In 2001, 82 percent of homes had some form of air-conditioning and 55 percent had central air; in 1970, only 36 percent of homes had airconditioning and 11 percent had central air. Housing has improved almost across the board. Now, 98.7 percent of homes have complete plumbing that includes sinks, hot water, and flush toilets compared with 93.5 percent thirty years ago. The improvement has been especially dramatic for low-income households. University of California at Berkeley professors Quigley and Raphael (2003) report that the percentage of homes occupied by the poorest onefifth of income earners that have incomplete plumbing declined from 40 percent in 1963 to essentially zero today. While the size and quality of homes have increased, so have prices. Between 1970 and 2001, the median price of owner-occupied housing rose from $78,051 to $123,887 (in 2001 dollars), leading a number of groups to declare a national affordability crisis. But despite noticeable price increases, housing is not necessarily unaffordable. The U.S. Census’s 2001 American Housing Survey estimates the cost of owning the median home at $725 per month. If 30 percent of income is spent on housing, any household earning $29,000 per year can purchase the median home. Median household income in the United States is much higher, at $41,994, and so spending $8,700 per year on the median home is well within reach. Although a nationwide affordability crisis does not exist, the numbers in certain regions are less rosy. In many areas of California and the Northeast, for example, housing is much more expensive than in the rest of the United States. Most commentators attribute the elevated prices to high demand for scarce land. A number of economists, however, point to another explanation. High prices may not be due to intrinsically valuable land but, instead, to housing regulations such as restrictions on density, height, and design; building fees; slow approval processes; restrictions on growth; and preservation laws. One way of measuring whether high prices are due to regulations or high demand for land is to look at how much increased lot size increases the value of a home. If land scarcity drives housing prices, doubling the lot size would increase the difference between construction costs and home value by 100 percent. But Edward Glaser and Joseph Gyourko (2002) found that consumers in most cities value homes on twenty-thousand-square-foot lots by only ten to twenty thousand dollars more than they do equivalent homes on ten-thousand-square-foot lots. This indicates that intrinsically valuable land is not the main cause of high prices. Economists who have studied the issue conclude that the scarcest input for housing is government permission to build. Econometric estimates indicate that only 10 percent of the gap between construction costs and home prices is caused by intrinsically high land prices; the other 90 percent is caused by zoning and land-use regulations. Glaser and Gyourko conclude that “land-use regulation is responsible for high housing costs where they exist” (p. 30). Another study reached the same conclusion using a different methodology. Stephen Malpezzi (1996) constructed an index of seven different land-use regulatory variables and ranked fifty-six different metropolitan areas according to how strictly land use was regulated. Regulatory variables included measures such as changes in length of approval time, time required to get land rezoned, amount of acreage zoned for residential development, and percentage of zoning changes approved. Malpezzi found that a change from a lightly regulated environment to a heavily regulated one increased home values by 51 percent and decreased the number of permits to build by 42 percent. Home ownership rates also declined by about ten percentage points. Regardless of methodology, evidence shows that areas with high levels of regulation have higher housing prices, higher rents, and lower home ownership rates. Although no national affordable housing crisis exists, prices are quite high in some high-regulation jurisdictions. In Santa Clara County, California, for example, the median price of a newly constructed home in 2003 was more than $638,000. Assuming a family can spend 30 percent of its income on a mortgage, even with low 5 percent interest rates a family must earn more than $135,000 per year to afford the median-priced new home. If the above estimates are correct, regulations such as urban growth boundaries, moratoriums on building permits, environmental regulations, and other restrictions raise home prices as much as $300,000 in this county. Put another way, the portion of purchase price paid by residents of Santa Clara County due to regulation is almost enough to buy three complete homes of median value elsewhere in the United States. In addition to land-use restrictions, governments drive up housing prices for lower-income families by dictating improvements in housing quality that the families might not otherwise choose. Governments do this by, for example, setting minimum lot sizes. Also, the federal government’s urban renewal program between 1949 and the early 1970s destroyed more than 600,000 low-income dwellings, replacing them with 250,000 homes that were mostly for middle- and upper-income buyers (O’Sullivan 1996). Martha Burt’s 1992 study found that urban renewal’s destruction of low-quality, low-cost residential hotel rooms in U.S. central cities contributed to the rise of homelessness. Real federal outlays for housing have steadily increased since the early 1960s to reach their current level of approximately thirty billion dollars per year. Today, approximately 6 million renter households receive federal housing subsidies, and 1.5 million households live in public housing. But the public sector lacks a profit incentive, and government programs are highly inefficient. One study estimated that for every hundred dollars of government spending on housing production, housing worth only forty-three dollars to the residents is produced (Mayo 1986). Because residents of public housing do not own it—and, indeed, no one owns it—public housing usually deteriorates rapidly through poor upkeep, in many cases becoming uninhabitable within twenty years. Some of the worst effects of public housing have been on the very residents the housing was created to help. Public housing projects are often plagued by high crime, and are thus considered undesirable places to live. In contrast, private developers and landlords have an incentive to make sure customers are satisfied: they lose business otherwise. Recognizing that government is not a particularly good landlord, many policymakers are looking for other “affordable” housing solutions. At the local level, inclusionary zoning is becoming increasingly popular. The word “inclusionary” actually refers to price controls on a percentage of new homes. Builders and subsequent owners are forced to price the homes so they are “affordable” to people at specific income levels. In Tiburon, California, for example, where the median price of existing homes exceeds $1 million, builders are required to sell 10 percent of new homes for $109,825 or less. Inclusionary zoning is most popular in California, Maryland, and New Jersey. A nationwide 1991 survey found that 9 percent of cities larger than 100,000 had inclusionary zoning, and the number is increasing rapidly. In 1990, roughly thirty jurisdictions in California had inclusionary zoning; the number had increased to more than one hundred by 2004. Inclusionary zoning produces negative effects similar to those caused by other price controls. Price controls restrict the supply of new homes and actually make housing less affordable. Because builders are forced to sell a portion of a development at a loss, inclusionary zoning functions as a tax on new construction. Estimates of the level of the tax in California cities such as Portola Valley are above $200,000 per market-rate home. To maintain normal profit margins, builders end up passing the tax on to landowners and other home buyers. Elasticities of supply and demand determine exactly how the burden is split, but the result is almost certainly higher home prices. Inclusionary zoning also leads to less construction. In the forty-five San Francisco Bay Area cities for which data are available, new construction fell by 31 percent in the year following the adoption of inclusionary zoning (Powell and Stringham 2004). In some cases, inclusionary zoning halts development completely. The experience of Watsonville, California, illustrates this effect. In 1990, Watsonville’s inclusionary zoning ordinance imposed price controls on 25 percent of new homes. Between 1990 and 1999, with the exception of a few small nonprofit developments, almost no new construction occurred. The law was finally revised in 1999 because, in the words of Watsonville Mayor Judy Doering-Nielsen, “There was an incredible pent-up demand. Our inclusionary housing ordinance was so onerous that developers wouldn’t come in.” Jan Davison, director of the city’s Redevelopment and Housing Department, commented that the inclusionary zoning law “was so stringent, and land costs were so high, that few units were produced,” but “[it] was completely redone in 2000, and we got more units produced” (Morgan 2003). Watsonville reduced the number of units under price controls from 25 percent of all developments to 15 percent on smaller developments and 20 percent on developments of fifty units or more. In the three years after easing requirements, the city’s housing stock increased by 12 percent. In addition to restricting supply, inclusionary zoning produces a number of other undesirable effects. Price controls exacerbate shortages, decrease mobility, and are a poor way of helping those most in need. Because inclusionary zoning comes with restrictions on resale, it prevents equity appreciation and leads families to live in the homes longer than they would otherwise. This takes homes off the market and does not help other low-income families who are seeking to buy homes. Even if a family’s income has considerably increased, owners of price-controlled homes are less able to move because price controls prevent their homes from appreciating at market rates. These residents are stuck with an asset that they cannot fully cash out and cannot even pass on to their children unless those children also meet low-income guidelines. This creates an incentive for owners to evade the law and resell or sublet their units at market rates. Governments then must spend resources supervising the price controls. Interestingly, even high-priced construction benefits all consumers. When a high-income household moves into a high-priced new home, it vacates its old home for someone else. That family, in turn, vacates its old residence, freeing it up for someone else. Economists call this process “filtering” because as new homes are built, the existing stock “filters down” to lower-income households. A classic study, New Homes and Poor People, looked at the chain of existing home sales in thirteen different cities and found that each new home generated an average of 3.5 moves. Even though new housing tends to be higher priced, low-income households make up to 14 percent of the moves generated by new housing. According to Malpezzi and Green (1996), “to the extent that a city makes it easy for any type of housing to be built, it will also enhance the available stock of low-cost housing” (p. 1811, italics added). When new construction is prevented or slowed, this process is stifled. Without new homes, high-income buyers bid up prices on existing homes, thus making all housing less affordable. A sure way to make housing more affordable is to reduce zoning regulations and other restrictions on new construction. Despite the regulations, the U.S. housing market is quite resilient. Ninety-eight percent of Americans live in privately owned and constructed homes. The size and quality of these homes have increased substantially over the past few decades. Some cities, such as Houston, Texas, have gone without zoning, and some, such as Celebration, Florida, are almost entirely privately planned. Developments such as Santana Row in San Jose, California, now provide streets, parks, and even private security. A shift away from government planning to private planning is positive for renters and homebuyers (Beito et al. 2002). About the Authors Benjamin Powell is an assistant professor of economics at San Jose State University and the director of the Center for Entrepreneurial Innovation at the Independent Institute. Edward Stringham is an assistant professor of economics at San Jose State University. Further Reading   Beito, David, Peter Gordon, and Alexander Tabarrok. The Voluntary City: Choice, Community, and Civil Society. Ann Arbor: University of Michigan Press, 2002. Burt, Martha. Over the Edge: The Growth of Homelessness During the 1980s. New York: Russell Sage Foundation, 1992. Glaeser, Edward, and Joseph Gyourko. “Zoning’s Steep Price.” Regulation (Fall 2002): 24-30. Green, Richard, and Stephen Malpezzi. A Primer on U.S. Housing Markets and Housing Policy. Washington, D.C: Urban Institute Press, 2003. Lansing, John, Charles Clifton, and James Morgan. New Homes and Poor People. Ann Arbor: Institute for Social Research, 1969. Malpezzi, Stephen. “Housing Prices, Externalities, and Regulation in U.S. Metropolitan Areas.” Journal of Housing Research 7, no. 2 (1996): 209-241. Malpezzi, Stephen, and Richard Green. “What Has Happened to the Bottom of the U.S. Housing Market?” Urban Studies 33, no. 10 (1996): 1807-1820. Mayo, Stephen. “Sources of Inefficiency in Subsidized Housing Programs: A Comparison of U.S. and German Experience.” Journal of Urban Economics 20 (1986): 229-249. Morgan, Terri. “Loosened Rules Lure Developers to Watsonville.” San Jose Mercury News, October 18, 2003. O’Sullivan, Arthur. Urban Economics. Chicago: Irwin/McGraw-Hill, 1996. Powell, Benjamin, and Edward Stringham. Housing Supply and Affordability: Do Affordable Housing Mandates Work? Policy Study no. 318. Reason Public Policy Institute, 2004. Quigley, John, and Steven Raphael. “Is Housing Unaffordable? Why Isn’t It More Affordable?” Journal of Economic Perspectives 18, no. 1 (2004): 191-214. U.S. Census Bureau. Annual Housing Survey, 1973: United States and Regions. Washington, D.C.: U.S. Census Bureau, 1975. U.S. Census Bureau. American Housing Survey for the United States: 2001. Washington, D.C.: U.S. Census Bureau, 2002.   (0 COMMENTS)

Inflation is a sustained increase in the aggregate price level. Hyperinflation is very high inflation. Although the threshold is arbitrary, economists generally reserve the term “hyperinflation” to describe episodes when the monthly inflation rate is greater than 50 percent. At a monthly rate of 50 percent, an item that cost $1 on January 1 would cost $130 on January 1 of the following year. Hyperinflation is largely a twentieth-century phenomenon. The most widely studied hyperinflation occurred in Germany after World War I. The ratio of the German price index in November 1923 to the price index in August 1922—just fifteen months earlier—was 1.02 × 1010. This huge number amounts to a monthly inflation rate of 322 percent. On average, prices quadrupled each month during the sixteen months of hyperinflation. While the German hyperinflation is better known, a much larger hyperinflation occurred in Hungary after World War II. Between August 1945 and July 1946 the general level of prices rose at the astounding rate of more than 19,000 percent per month, or 19 percent per day. Even these very large numbers understate the rates of inflation experienced during the worst days of the hyperinflations. In October 1923, German prices rose at the rate of 41 percent per day. And in July 1946, Hungarian prices more than tripled each day. What causes hyperinflations? No single shock, no matter how severe, can explain sustained, continuously rapid growth in prices. The world wars themselves did not cause the hyperinflations in Germany and Hungary. The destruction of resources during the wars can explain why prices in Germany and Hungary would be higher after the wars than before. But the wars themselves cannot explain why prices would continuously rise at rapid rates during hyperinflation periods. Hyperinflations are caused by extremely rapid growth in the supply of “paper” money. They occur when the monetary and fiscal authorities of a nation regularly issue large quantities of money to pay for a large stream of government expenditures. In effect, inflation is a form of taxation in which the government gains at the expense of those who hold money while its value is declining. Hyperinflations are very large taxation schemes. During the German hyperinflation the number of German marks in circulation increased by a factor of 7.32 × 109. In Hungary, the comparable increase in the money supply was 1.19 × 1025. These numbers are smaller than those given earlier for the growth in prices. What does it mean when prices increase more rapidly than the supply of money? Economists use a concept called the “real quantity of money” to discuss what happens to people’s money-holding behavior when prices grow rapidly. The real quantity of money, sometimes called the “purchasing power of money,” is the ratio of the amount of money held to the price level. Imagine that the typical household consumes a certain bundle of goods. The real quantity of money measures the number of bundles a household could buy with the money it holds. In low-inflation periods, a household will maintain a high real money balance because it is convenient to do so. In high-inflation periods, a household will maintain a lower real money balance to avoid the inflation “tax.” They avoid the inflation tax by holding more of their wealth in the form of physical commodities. As they buy these commodities, prices rise higher and inflation increases. Figure 1 shows real money balances and inflation for Germany from the beginning of 1919 until April 1923. The graph indicates that Germans lowered real balances as inflation increased. The last months of the German hyperinflation are not pictured in the figure because the inflation rate was too high to preserve the scale of the graph. Hyperinflations tend to be self-perpetuating. Suppose a government is committed to financing its expenditures by issuing money and begins by raising the money stock by 10 percent per month. Soon the rate of inflation will increase, say, to 10 percent per month. The government will observe that it can no longer buy as much with the money it is issuing and is likely to respond by raising money growth even further. The hyperinflation cycle has begun. During the hyperinflation there will be a continuing tug-of-war between the public and the government. The public is trying to spend the money it receives quickly in order to avoid the inflation tax; the government responds to higher inflation with even higher rates of money issue. Most economists agree that inflation lowers economic welfare even when allowing for revenue from the inflation tax and the distortion that would be created by alternative taxes that raise the same revenue.1 Figure 1 During the German Hyperinflation, the Real Quantity of Money Fell as Inflation Increased ZOOM   How do hyperinflations end? The standard answer is that governments have to make a credible commitment to halting the rapid growth in the stock of money. Proponents of this view consider the end of the German hyperinflation to be a case in point. In late 1923, Germany undertook a monetary reform, creating a new unit of currency called the rentenmark. The German government promised that the new currency could be converted on demand into a bond having a certain value in gold. Proponents of the standard answer argue that the guarantee of convertibility is properly viewed as a promise to cease the rapid issue of money. An alternative view held by some economists is that not just monetary reform, but also fiscal reform, is needed to end a hyperinflation. According to this view, a successful reform entails two believable commitments on the part of government. The first is a commitment to halt the rapid growth of paper money. The second is a commitment to bring the government’s budget into balance. This second commitment is necessary for a successful reform because it removes, or at least lessens, the incentive for the government to resort to inflationary taxation. If the government commits to balancing its budget, people can reasonably believe that money growth will not rise again to high levels in the near future. Thomas Sargent, a proponent of the second view, argues that the German reform of 1923 was successful because it created an independent central bank that could refuse to monetize the government deficit and because it included provisions for higher taxes and lower government expenditures. Another way to look at Sargent’s view is that hyperinflations end when people reasonably believe that the rate of money growth will fall to normal levels both now and in the future. What effects do hyperinflations have? One effect with serious consequences is the reallocation of wealth. Hyperinflations transfer wealth from the general public, which holds money, to the government, which issues money. Hyperinflations also cause borrowers to gain at the expense of lenders when loan contracts are signed prior to the worst inflation. Businesses that hold stores of raw materials and commodities gain at the expense of the general public. In Germany, renters gained at the expense of property owners because rent ceilings did not keep pace with the general level of prices. Costantino Bresciani-Turroni argues that the hyperinflation destroyed the wealth of the stable classes in Germany and made it easier for the National Socialists (Nazis) to gain power. Hyperinflation reduces an economy’s efficiency by driving people away from monetary transactions and toward barter. In a normal economy, using money in exchange is highly efficient. During hyperinflations people prefer to be paid in commodities in order to avoid the inflation tax. If they are paid in money, they spend that money as quickly as possible. In Germany, workers were paid twice per day and would shop at midday to avoid further depreciation of their earnings. Hyperinflation is a wasteful game of “hot potato” in which people use up valuable resources trying to avoid holding on to paper money. Hyperinflations can lead to behavior that would be thought bizarre under normal conditions. Gerald Feldman’s book The Great Disorder shows a photo of a small firm transporting wages in a wheelbarrow because the number of banknotes required to pay workers grew very large during the hyperinflation (Feldman 1993, p. 680). Corbis, an Internet source of photos (www.corbis.com), shows an image of a German woman burning banknotes in her stove because doing so provided more heat than using them to buy other fuel would have done. Another image shows German children playing with blocks of banknotes in the street. More-recent examples of very high inflation have occurred mostly in Latin America and former Eastern bloc nations. Argentina, Bolivia, Brazil, Chile, Peru, and Uruguay together experienced an average annual inflation rate of 121 percent between 1970 and 1987. In Bolivia, prices increased by 12,000 percent in 1985. In Peru, a near hyperinflation occurred in 1988 as prices rose by about 2,000 percent for the year, or by 30 percent per month. However, Thayer Watkins documents that the record hyperinflation of all time occurred in Yugoslavia between 1993 and 1994.2 The Latin American countries with high inflation also experienced a phenomenon called “dollarization,” the use of U.S. dollars in place of the domestic currency. As inflation rises, people come to believe that their own currency is not a good way to store value and they attempt to exchange their domestic money for dollars. In 1973, 90 percent of time deposits in Bolivia were denominated in Bolivian pesos. By 1985, the year of the Bolivian hyperinflation, more than 60 percent of time deposit balances were denominated in dollars. What caused high inflation in Latin America? Many Latin American countries borrowed heavily during the 1970s and agreed to repay their debts in dollars. As interest rates rose, all of these countries found it increasingly difficult to meet their debt service obligations. The high-inflation countries were those that responded to these higher costs by printing money. The Bolivian hyperinflation is a case in point. Eliana Cardoso explains that in 1982 Hernán Siles Suazo took power as head of a leftist coalition that wanted to satisfy demands for more government spending on domestic programs but faced growing debt service obligations and falling prices for its tin exports. The Bolivian government responded to this situation by printing money. Faced with a shortage of funds, it chose to raise revenue through the inflation tax instead of raising income taxes or reducing other government spending. About the Author Michael K. Salemi is an economics professor at the University of North Carolina in Chapel Hill. Further Reading Introductory   Bresciani-Turroni, Costantino. The Economics of Inflation: A Study of Currency Depreciation in Post-war Germany. New York: Augustus M. Kelley, 1937. A readable classic originally written in Italian. Cardoso, Eliana A. “Hyperinflation in Latin America.” Challenge (January/February 1989): 11-19. Interesting and accessible. Federal Reserve Bank of San Francisco. “The Optimal Rate of Inflation.” FRBSF Economic Letter 97-27, September 19, 1997. A very readable overview of theoretical analyses of the welfare effects of inflation. Feldman, Gerald. The Great Disorder. Oxford: Oxford University Press, 1993. Source of the wheelbarrow picture. Graham, Frank D. Exchange, Prices, and Production in Hyperinflation Germany, 1920-1923. New York: Russell and Russell, 1930. Readable with a focus on data. Holtfrerich, Carl-Ludwig. The German Inflation 1914-1923: Causes and Effects in International Perspective. New York: De Gruyter, 1986. Written by an economist who worked with German archives. Sargent, Thomas J. “The Ends of Four Big Inflations.” In Rational Expectations and Inflation. New York: Harper and Row, 1986. Sargent explains in detail why fiscal reform is needed to end hyperinflations. Salemi, Michael, and Sarah Leak. Analyzing Inflation and Its Control: A Resource Guide. New York: National Council on Economic Education, 1984. Designed to help high school teachers teach about inflation.   Advanced   Bomberger, William A., and Gail E. Makinen. “The Hungarian Hyperinflation and Stabilization of 1945-1946.” Journal of Political Economy 91 (October 1983): 801-824. Cagan, Phillip. “The Monetary Dynamics of Hyperinflation.” In Milton Friedman, ed., Studies in the Quantity Theory of Money. Chicago: University of Chicago Press, 1956. Fischer, Stanley, Ratna Sahay, and Carlos A. Vegh. “Modern Hyper- and High Inflations.” Journal of Economic Literature 40, no. 3 (2002): 837–880. A comprehensive look at modern episodes and theory. Salemi, Michael. “Hyperinflation, Exchange Depreciation, and the Demand for Money in Post World War I Germany.” Ph.D. diss., University of Minnesota, 1976.   Footnotes 1. For more on the “optimal” rate of inflation, see Timothy Cogley, “What Is the Optimal Rate of Inflation,” FRSBSF Economic Letter 97-27, online at: http://www.sf.frb.org/econrsrch/wklyltr/el97-27.html.   2. See http://www.sjsu.edu/faculty/watkins/hyper.htm.   (0 COMMENTS)

To most people, capital means a bank account, a hundred shares of IBM stock, assembly lines, or steel plants in the Chicago area. These are all forms of capital in the sense that they are assets that yield income and other useful outputs over long periods of time. But such tangible forms of capital are not the only type of capital. Schooling, a computer training course, expenditures on medical care, and lectures on the virtues of punctuality and honesty are also capital. That is because they raise earnings, improve health, or add to a person’s good habits over much of his lifetime. Therefore, economists regard expenditures on education, training, medical care, and so on as investments in human capital. They are called human capital because people cannot be separated from their knowledge, skills, health, or values in the way they can be separated from their financial and physical assets. Education, training, and health are the most important investments in human capital. Many studies have shown that high school and college education in the United States greatly raise a person’s income, even after netting out direct and indirect costs of schooling, and even after adjusting for the fact that people with more education tend to have higher IQs and better-educated, richer parents. Similar evidence covering many years is now available from more than a hundred countries with different cultures and economic systems. The earnings of more-educated people are almost always well above average, although the gains are generally larger in less-developed countries. Consider the differences in average earnings between college and high school graduates in the United States during the past fifty years. Until the early 1960s, college graduates earned about 45 percent more than high school graduates. In the 1960s, this premium from college education shot up to almost 60 percent, but it fell back in the 1970s to less than 50 percent. The fall during the 1970s led some economists and the media to worry about “overeducated Americans.” Indeed, in 1976, Harvard economist Richard Freeman wrote a book titled The Overeducated American. This sharp fall in the return to investments caused doubt about whether education and training really do raise productivity or simply provide signals (“credentials”) about talents and abilities. But the monetary gains from a college education rose sharply again during the 1980s, to the highest level since the 1930s. Economists Kevin M. Murphy and Finis Welch have shown that the premium on getting a college education in the 1980s was above 65 percent. This premium continued to rise in the 1990s, and in 1997 it was more than 75 percent. Lawyers, accountants, engineers, and many other professionals experienced especially rapid advances in earnings. The earnings advantage of high school graduates over high school dropouts has also greatly increased. Talk about overeducated Americans has vanished, replaced by concern about whether the United States provides adequate quality and quantity of education and other training. This concern is justified. Real wage rates of young high school dropouts have fallen by more than 25 percent since the early 1970s. This drop is overstated, though, because the inflation measure used to compute real wages overstates the amount of inflation over that time (see consumer price indexes). Real wages for high school dropouts stayed constant from 1995 to 2004, which means, given the price index used to adjust them, that these wages have increased somewhat. Thinking about higher education as an investment in human capital helps us understand why the fraction of high school graduates who go to college increases and decreases from time to time. When the benefits of a college degree fell in the 1970s, for example, the fraction of white high school graduates who started college fell—from 51 percent in 1970 to 46 percent in 1975. Many educators expected that enrollments would continue to decline in the 1980s, partly because the number of eighteen-year-olds was declining, but also because college tuition was rising rapidly. They were wrong about whites. The fraction of white high school graduates who entered college rose steadily in the 1980s, reaching 60 percent in 1988, and caused an absolute increase in the number of whites enrolling despite the smaller number of college-aged people. That percentage kept increasing to an all-time high of 67 percent in 1997 and then declined slightly to 64 percent in 2000. This makes sense. The benefits of a college education, as noted, increased in the 1980s and 1990s. Tuition and fees did rise by about 39 percent from 1980 to 1986, and by 20 percent more from 1989 to 2000 in real, inflation-adjusted terms (again, using the faulty price indexes available). But tuition and fees are not, for most college students, the major cost of going to college. On average, three-fourths of the private cost of a college education—the cost borne by the student and the student’s family—is the income that college students give up by not working. A good measure of this “opportunity cost” is the income that a newly minted high school graduate could earn by working full time. During the 1980s and 1990s, this forgone income rose only about 4 percent in real terms. Therefore, even a 67 percent increase in real tuition costs in twenty years translated into an increase of just 20 percent in the average student’s total cost of a college education. The economics of human capital also account for the fall in the fraction of black high school graduates who went on to college in the early 1980s. As UCLA economist Thomas J. Kane has pointed out, costs rose more for black college students than for whites. That is because a higher percentage of blacks are from low-income families, and therefore had been heavily subsidized by the federal government. Cuts in federal grants to them in the early 1980s substantially raised their cost of a college education. In the 1990s, however, there was a substantial recovery in the percentage of black high school graduates going on to college. According to the 1982 “Report of the Commission on Graduate Education” at the University of Chicago, demo-graphic-based college enrollment forecasts had been wide of the mark during the twenty years prior to that time. This is not surprising to a “human capitalist.” Such forecasts ignored the changing incentives—on the cost side and on the benefit side—to enroll in college. The economics of human capital have brought about a particularly dramatic change in the incentives for women to invest in college education in recent decades. Prior to the 1960s, American women were more likely than men to graduate from high school, but less likely to go to college. Women who did go to college shunned or were excluded from math, sciences, economics, and law, and gravitated toward teaching, home economics, foreign languages, and literature. Because relatively few married women continued to work for pay, they rationally chose an education that helped in “household production”—and no doubt also in the marriage market—by improving their social skills and cultural interests. All this has changed radically. The enormous increase in the labor participation of married women is the most important labor force change during the past twenty-five years. Many women now take little time off from their jobs, even to have children. As a result, the value to women of market skills has increased enormously, and they are bypassing traditional “women’s” fields to enter accounting, law, medicine, engineering, and other subjects that pay well. Indeed, women now constitute about one-third of enrollments in business schools, more than 45 percent in law schools, and more than 50 percent in medical schools. Many home economics departments have either shut down or are emphasizing the “new home economics”—that is, the economics of whether to get married, how many children to have, and how to allocate household resources, especially time. Improvements in the economic position of black women have been especially rapid, and black women now earn almost as much as white women.1 Of course, formal education is not the only way to invest in human capital. Workers also learn and are trained outside schools, especially on the job. Even college graduates are not fully prepared for the labor market when they leave school and must be fitted into their jobs through formal and informal training programs. The amount of on-the-job training ranges from an hour or so at simple jobs like dishwashing to several years at complicated tasks like engineering in an auto plant. The limited data available indicate that on-the-job training is an important source of the very large increase in earnings that workers get as they gain greater experience at work. Bold estimates by Columbia University economist Jacob Mincer suggest that the total investment in on-the-job training may be well above $200 billion a year, or about 2 percent of GDP. No discussion of human capital can omit the influence of families on the knowledge, skills, health, values, and habits of their children. Parents affect educational attainment, marital stability, propensities to smoke and to get to work on time, and many other dimensions of their children’s lives. The enormous influence of the family would seem to imply a very close relation between the earnings, education, and occupations of parents and children. Therefore, it is rather surprising that the positive relation between the earnings of parents and children is not so strong, although the relation between the years of schooling of parents and their children is stronger. For example, if fathers earn 20 percent above the mean of their generation, sons at similar ages tend to earn about 8-10 percent above the mean of theirs. Similar relations hold in Western European countries, Japan, Taiwan, and many other places. Statisticians and economists call this “regression to the mean.” The old adage of “from shirtsleeves to shirtsleeves in three generations” (the idea being that someone starts with hard work and then creates a fortune for the next generation that is then dissipated by the third generation) is no myth; the earnings of grandsons and grandparents at comparable ages are not closely related.2 Apparently, the opportunities provided by a modern economy, along with extensive government and charitable support of education, enable the majority of those who come from lower-income backgrounds to do reasonably well in the labor market. The same opportunities that foster upward mobility for the poor create an equal amount of downward mobility for those higher up on the income ladder. The continuing growth in per capita incomes of many countries during the nineteenth and twentieth centuries is partly due to the expansion of scientific and technical knowledge that raises the productivity of labor and other inputs in production. And the increasing reliance of industry on sophisticated knowledge greatly enhances the value of education, technical schooling, on-the-job training, and other human capital. New technological advances clearly are of little value to countries that have very few skilled workers who know how to use them. Economic growth closely depends on the synergies between new knowledge and human capital, which is why large increases in education and training have accompanied major advances in technological knowledge in all countries that have achieved significant economic growth. The outstanding economic records of Japan, Taiwan, and other Asian economies in recent decades dramatically illustrate the importance of human capital to growth. Lacking natural resources—they import almost all their energy, for example—and facing discrimination against their exports by the West, these so-called Asian tigers grew rapidly by relying on a well-trained, educated, hardworking, and conscientious labor force that makes excellent use of modern technologies. China, for example, is progressing rapidly by mainly relying on its abundant, hardworking, and ambitious population. About the Author Gary S. Becker is university professor of economics and sociology at the University of Chicago, a professor at the Graduate School of Business, and the Rose-Marie and Jack R. Anderson Senior Fellow at Stanford’s Hoover Institution. He was a pioneer in the study of human capital and was awarded the 1992 Nobel Memorial Prize in Economic Sciences (see also biographies section). Further Reading   Becker, Gary S. Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education. 2d ed. New York: Columbia University Press for NBER, 1975. Freeman, Richard. The Overeducated American. New York: Academic Press, 1976. Kane, Thomas J. “College Attendance by Blacks Since 1970: The Role of College Cost, Family Background and the Returns to Education.” Journal of Political Economy 102 (1994): 878-911. Mincer, Jacob. “Investment in U.S. Education and Training.” NBER Working Paper no. 4844. National Bureau of Economic Research, Cambridge, Mass., 1994. Murphy, Kevin M., and Finis Welch. “Wage Premiums for College Graduates: Recent Growth and Possible Explanations.” Educational Researcher 18 (1989): 17-27. National Center for Education Statistics. “Digest of Education Statistics 2001.” NCES 2002-130. U.S. Department of Education, March 2002. National Center for Education Statistics. “Paying for College—Changes Between 1990 and 2000 for Full-Time Dependent Undergraduates.” NCES 2004-075. U.S. Department of Education, June 2004. National Center for Education Statistics. “Projections of Education Statistics to 2012.” NCES 2002-030. U.S. Department of Education, October 2002. “Report of the Commission on Graduate Education.” University of Chicago Record 16, no. 2 (1982): 67-180. Topel, Robert. “Factor Proportions and Relative Wages: The Supply Side Determinants of Wage Inequality.” Journal of Economic Perspectives II (Spring 1997): 55-74. Welch, Finis, ed. The Causes and Consequences of Increasing Inequality. Bush School Series in the Economics of Public Policy. Chicago: University of Chicago Press, 2001.   Footnotes 1. National Center for Education Statistics, “Educational Achievement and Black-White Inequality,” NCES 2001-061, U.S. Department of Education, 2001.   2. Gary Solon, “Intergenerational Income Mobility in the United States,” American Economic Review 82 (June 1992): 393-408.   (0 COMMENTS)

Game theory is the science of strategy. It attempts to determine mathematically and logically the actions that “players” should take to secure the best outcomes for themselves in a wide array of “games.” The games it studies range from chess to child rearing and from tennis to takeovers. But the games all share the common feature of interdependence. That is, the outcome for each participant depends on the choices (strategies) of all. In so-called zero-sum games the interests of the players conflict totally, so that one person’s gain always is another’s loss. More typical are games with the potential for either mutual gain (positive sum) or mutual harm (negative sum), as well as some conflict. Game theory was pioneered by Princeton mathematician john von neumann. In the early years the emphasis was on games of pure conflict (zero-sum games). Other games were considered in a cooperative form. That is, the participants were supposed to choose and implement their actions jointly. Recent research has focused on games that are neither zero sum nor purely cooperative. In these games the players choose their actions separately, but their links to others involve elements of both competition and cooperation. Games are fundamentally different from decisions made in a neutral environment. To illustrate the point, think of the difference between the decisions of a lumberjack and those of a general. When the lumberjack decides how to chop wood, he does not expect the wood to fight back; his environment is neutral. But when the general tries to cut down the enemy’s army, he must anticipate and overcome resistance to his plans. Like the general, a game player must recognize his interaction with other intelligent and purposive people. His own choice must allow both for conflict and for possibilities for cooperation. The essence of a game is the interdependence of player strategies. There are two distinct types of strategic interdependence: sequential and simultaneous. In the former the players move in sequence, each aware of the others’ previous actions. In the latter the players act at the same time, each ignorant of the others’ actions.

Futures Markets In the late 1970s and early 1980s, radical changes in the international currency system and in the way the Federal Reserve managed the U.S. money supply produced unprecedented volatility in interest rates and currency exchange rates. As market forces shook the foundations of global financial stability, businesses wrestled with heretofore unimagined challenges. Between 1980 and 1985, Caterpillar, the Peoria-based maker of heavy equipment, saw exchange-rate shifts give its main Japanese competitor a 40 percent price advantage. Meanwhile, even the soundest business borrowers faced soaring double-digit interest rates. Investors clamored for dollars as commodity prices collapsed, taking whole nations down into insolvency and ushering in the Third World debt crisis. Stymied financial managers turned to Chicago, where the traditional agricultural futures markets had only recently invented techniques to cope with financial uncertainty. In 1972, the Chicago Mercantile Exchange established the International Monetary Market to trade the world’s first futures contracts for currency. The world’s first interest-rate futures contract was introduced shortly afterward, at the Chicago Board of Trade, in 1975. In 1982, futures contracts on the Standard and Poor’s 500 index began to trade at the Chicago Mercantile Exchange. These radically new tools helped businesses manage in a volatile and unpredictable new world order. How? Futures are standardized contracts that commit parties to buy or sell goods of a specific quality at a specific price, for delivery

When economists speak of the “gender gap” these days, they usually are referring to systematic differences in the outcomes that men and women achieve in the labor market. These differences are seen in the percentages of men and women in the labor force, the types of occupations they choose, and their relative incomes or hourly wages. These economic gender gaps, which were salient issues during the women’s movement in the 1960s and 1970s, have been of interest to economists at least since the 1890s. Figure 1 Labor Force Participation Rates of Men and Women, 25-44 Years Old, 1890-2000

After World War II the German economy lay in shambles. The war, along with Hitler’s scorched-earth policy, had destroyed 20 percent of all housing. Food production per capita in 1947 was only 51 percent of its level in 1938, and the official food ration set by the occupying powers varied between 1,040 and 1,550 calories per day. Industrial output in 1947 was only one-third its 1938 level. Moreover, a large percentage of Germany’s working-age men were dead. At the time, observers thought that West Germany would have to be the biggest client of the U.S. welfare state; yet, twenty years later its economy was envied by most of the world. And less than ten years after the war people already were talking about the German economic miracle. What caused the so-called miracle? The two main factors were currency reform and the elimination of price controls, both of which happened over a period of weeks in 1948. A further factor was the reduction of marginal tax rates later in 1948 and in 1949. Before By 1948 the German people had lived under price controls for twelve years and rationing for nine years. Adolf Hitler had imposed price controls on the German people in 1936 so that his government could buy war materials at artificially low prices. Later, in 1939, one of Hitler’s top Nazi deputies, Hermann Goering, imposed rationing. (Roosevelt and Churchill also imposed price controls and rationing, as governments tend to do during all-out wars.) During the war, the Nazis made flagrant violations of the price controls subject to the death penalty.1 In November 1945 the Allied Control Authority, formed by the governments

We live in a greenhouse world; without such gases Earth would be too cold to sustain life as we know it. Water vapor, the principal molecule that keeps us warm, accounts for almost all (98 percent) of the natural heating of the world. Other gases, such as carbon dioxide (CO2), methane (CH4), and nitrous oxide (N2O), also contribute to a warmer world. Over the last three hundred years, as the world has industrialized and become more and more dependent on fossil fuels, the concentration of CO2 in the atmosphere has increased by more than 30 percent while methane concentrations, mainly from agriculture, have increased by about 150 percent. Atmospheric scientists have predicted that increases in those greenhouse gases will lead to, or are already producing, a warmer world. The Intergovernmental Panel on Climate Change (IPCC, a UN body tasked with the science of global warming) believes that if nothing is done to slow global warming, the amount of CO2 will have doubled by the year 2060, causing the world’s temperature to rise by about 2.5°C (4.5°F). Interestingly, Swedish scientist Svante Arrhenius, the first to predict global warming (1896), believed that it would be beneficial, especially for northern countries. In 1992, however, the fear of harm from global warming led most of the world’s national governments, including the U.S. government, to sign the United Nations Framework Convention on Climate Change at the Earth Summit in Rio de Janeiro. These governments pledged to take voluntary steps to cap carbon emissions at 1990 levels by the year 2000. The U.S. Senate ratified that treaty later in 1992. International activity continued with a subsequent meeting in Berlin (1995), followed by the meeting in Kyoto (1997) that negotiated a protocol mandating emission reductions by the advanced countries of the world but exempting the rest of the globe. The Clinton administration signed the protocol, knowing that with large countries like China and India excluded, the Senate would be unlikely to ratify it. Indeed, President Clinton refused to send the protocol to the Senate for ratification, and the Senate voted 95–0 against any treaty that excluded some countries. Shortly after taking office, George W. Bush announced that the United States was withdrawing from the treaty on the

Government debt is the stock of outstanding IOUs issued by the government at any time in the past and not yet repaid. Governments issue debt whenever they borrow from the public; the magnitude of the outstanding debt equals the cumulative amount of net borrowing that the government has done. The deficit is the addition in the current period (year, quarter, month, etc.) to the outstanding debt. The deficit is negative whenever the value of outstanding debt falls; a negative deficit is called a surplus. When the government borrows, it gives its creditors government securities stating the terms of the loan: the principal being borrowed, the interest rate to be paid on the principal, and the schedule for making the interest payments and principal repayment. The amount of outstanding securities equals the amount of debt that has not yet been repaid; that amount is called “the government debt.” Governments issue several types of debt, which can be classified in various ways. One classification is by the type of government that issued the debt. In the United States, the main divisions are federal, state, and local debt; local debt can be divided further by type of locality, such as county or city (see bonds). A second classification of government debt is by maturity at the time of issue. When we talk about a ten-year bond or a thirty-year bond, we are talking about the length of time between the date when the bond was first issued and the date on which the principal will be repaid. Federal debt is divided into three convenient maturity categories. Treasury bills have initial maturities of one year or less (“three-month bills,” “year bills,” etc.); treasury notes have initial maturities between one and ten years; and treasury bonds have initial maturities longer than ten years. State and local government securities generally are just called bonds, irrespective of the initial maturity. A perpetuity is a bond with an infinite maturity, which means the principal is never repaid and interest payments are made forever. The British government once issued perpetuities, calling them “consols.” A third way of classifying government securities is by the source of the revenue to repay them. “General obligation bonds” will be repaid with revenue collected by taxing the public; “revenue bonds” will be repaid with revenue collected from specific user fees, such as bridge or highway tolls. This way of classifying debt is used only for state and local debt. In early 2004, there was about $7.1 trillion of federal debt outstanding. About half ($3.6 trillion) was held by federal agencies and trust funds, which means that the government owed half the debt to itself. Such internal debt has no implications for the economy or public welfare. The important number is the amount of federal debt held by private investors, which in early 2004 was about $3.5 trillion. Foreigners held about $1.7 trillion of that amount. State and local government debt outstanding was another $1.6 trillion, most of which was held by private investors. Thus, the total amount of privately held government debt was about $5.1 trillion. As a fraction of gross domestic product (GDP) of the U.S. economy, government debt is not especially large. As of the end of 2003, GDP was about $11.1 trillion, a little more than twice the size of the privately held government debt. In contrast, at the end of World War II, outstanding federal debt alone was slightly larger than GDP. Another interesting comparison is between government debt and private debt. Corporate debt outstanding was about $5.0 trillion at the end of 2003, almost exactly the same amount as privately held government debt. Household debt is even larger. At the end of 2003, household credit market debt stood at $9.5 trillion, nearly twice the size of privately held government debt. For some reason, attitudes toward these different stocks of debt are somewhat inconsistent. Commentators regularly express concern that the sizes of government and household debt represent a risk to the economy, yet no one seems to worry much about the size of corporate debt. In fact, household and corporate debt may represent a risk in some circumstances, but government debt essentially never does. In a deep recession, debtors may become unable to repay their debts and choose to default on them. That, in turn, can make financial institutions insolvent, leading to a collapse of the financial system and a cessation of the intermediary functions that they perform. Indeed, such a mechanism was the proximate cause for the recession of 1929 turning into the great depression of 1932. Rarely, however, does any government in the United States default on its debt; the federal government has never defaulted. The size of the outstanding government debt is a topic of perennial interest. The obvious measurement of the debt’s size is the sum of all the individual outstanding government securities. That number often is reported in newspaper accounts and political debates, but, to be useful, it must be adjusted. The most important adjustment is for inflation. The nominal value of a bond is the price in dollars that it would fetch on the open market. The real value of that same bond is the number of units of output that it can buy. If chocolate bars cost twenty-five cents apiece, then the real value of a ten-dollar bond is forty chocolate bars. If, however, the prices of all goods double, so that chocolate bars now cost fifty cents each, then the real value of the same ten-dollar bond is cut in half, and the bond now buys only twenty chocolate bars. The bond’s nominal value is unchanged by inflation, but its real value is changed. Real, not nominal, values are what matters because people are interested in how many goods they can buy with the wealth their bonds represent—which is precisely what the real value measures. Adjusting official debt and deficit figures for inflation can make a big difference to measurements of the debt’s size. For example, the official statistics report a federal surplus of $6.6 billion for 1947. Inflation that year was nearly 15 percent, however, and this inflation reduced the value of the huge outstanding debt by about $11.4 billion. That reduction was equivalent to a further surplus because it reduced the real value of what the federal government owed its creditors. The true surplus, therefore, was about $18 billion, nearly three times as high as the official figure. Throughout the 1970s, while the official federal deficit was positive every year, the inflation-corrected deficit was negative (i.e., there was a real surplus) in exactly half those years. Another adjustment is for changes in interest rates. The value of outstanding debt changes as market interest rates change, but newspaper accounts usually report par values, which do not adjust for interest rate changes. Market values do account for interest rate changes and can be quite different from par values. To see what is involved, suppose that you buy a one-year $5,000 municipal bond (equivalently, you make a loan of $5,000 to the city that issued the bond) at 11:00 a.m. The bond carries an interest rate of 10 percent, which means you will be paid $500 in interest when the bond matures one year from now. At 11:05 a.m., the Federal Reserve announces a change in monetary policy that causes one-year interest rates to fall to 9 percent. Your bond now is worth more than it was when you bought it five minutes ago; that is, you could now sell the bond to someone else for more than $5,000. The reason is that anyone who wants to lend $5,000 for one year now will find that new bonds pay only 9 percent, meaning an interest payment in one year of $450. Your “old” bond, however, has a 10 percent rate locked in and will pay $500 interest for sure. That makes your bond’s market value higher than its par value of $5,000. Conversion to market value can raise or lower the size of the outstanding debt. The market value of outstanding debt will be greater than the par value if interest rates have fallen on average since the debt was issued and will be smaller than the par value if rates have risen. The difference between par value and market value of the outstanding debt is typically a few percentage points. Unfortunately, market values for the total outstanding government debt are not readily available. Governments do not report them, which is why newspaper reports rarely mention them. More important than the sheer size of government debt are the debt’s effects on the economy. Economists do not fully agree on what those effects are. When the government borrows, it promises to repay the lender. To make those repayments the government ultimately will have to raise extra taxes, beyond what it needs to pay for its other activities. The economic effect of government debt depends heavily on how taxpayers perceive those future taxes. Perceptions are difficult to measure, and neither economists nor others understand exactly how people form their perceptions. To see what is at issue, consider a simple example. Suppose that every year the government buys $100 billion worth of goods and services and pays for them entirely by collecting taxes. Households pay the government $100 billion in tax revenue, and the government uses the revenue to buy goods and services. Revenue equals expenditure, so the government’s budget is balanced. Suppose the government suddenly decides to change the way it finances its expenditures, but not the amount spent. In the first year, the government reduces taxes by $10 billion and replaces the lost revenue by selling $10 billion worth of bonds that mature in one year and carry an interest rate of 10 percent a year. In the second year, the bonds mature, and the government pays the $10 billion principal and the $1 billion of interest. Taxes in the first year are $10 billion lower, but in the second year they are $11 billion higher. How does this temporal rearrangement of tax collections affect people? In the first year, people hand over the same revenue to the government as they did when they paid taxes; the difference is that $10 billion of it is now in the form of a loan that will be repaid in the second year with an extra $1 billion in interest. On this account, people may feel richer because they seem to be paying less in total taxes over the two periods. When the second year arrives, however, people will find that they have nothing extra at all because, to pay the $11 billion in principal and interest, the government must raise taxes by exactly $11 billion, which cancels the payment of the principal and interest. The government giveth with one hand and taketh away with the other. The net result is that people do not get back the $10 billion they lent the government, and the loan is equivalent to having paid the $10 billion in taxes in the first year. This same result emerges from any maturity of debt, whether it is a one-year bond, as in the previous example, a ten-year bond, or even a perpetuity. The crucial factor in determining how bond finance affects the economy is whether people recognize what is going to happen over time. If everybody foresees that future taxes will nullify future payments of principal and interest, then bond finance is equivalent to tax finance, and government debt has no effect on anything important. This property is known as “Ricardian equivalence,” after David Ricardo, the economist who first discussed it. If people do not foresee all the future taxes implied by government debt, then they feel wealthier when the debt is issued but poorer in the future when, unexpectedly, they have to pay higher taxes to finance the principal and interest payments. So, what do people expect? Unfortunately, there is no reliable way to discover people’s expectations about taxes, and we have to use other methods to learn the effect of government debt on the economy. Even though economists have been studying this issue for more than twenty years, they have not yet reached a consensus. Direct measures of the effect of debt on economic activity are straightforward in principle but difficult to construct in practice. Overall, though, the evidence favors approximate Ricardian equivalence. If government debt is equivalent to taxation, then most of the public discussion of the “deficit problem” is misplaced. Under equivalence, government deficits merely rearrange the timing of tax collections in a way that people can anticipate and offset; no important economic effects arise. With incomplete equivalence, deficits affect the economy, but the effects are complicated. For example, suppose people do not recognize any of the future taxes implied by current deficits. In that case, partially replacing current tax collections with borrowing makes people feel wealthier today, which induces them to spend more; however, the taxes needed to repay the debt will eventually have to be collected. Because no one anticipated them, they will come as a surprise, inducing people unexpectedly to spend less in whatever period the taxes are levied. A deficit or surplus thus has effects not just in the period when the deficit or surplus occurs, but also in subsequent periods. Predicting the magnitude and timing of the sequence of effects is difficult. A related issue is the desirability of deliberately using deficits to influence the path of the economy. Under full equivalence of deficit and tax finance, no such thing can be done, of course, because deficits do not affect anything important. Under incomplete equivalence, though, deficits do have effects, as we have just seen. Therefore, it might seem desirable to run up deficits in recessions to encourage people to spend more and to run up surpluses in booms to restrain spending. One problem is that these seemingly desirable effects arise only because people fail to perceive the future taxes implied by deficits; that is, deficits have effects only when they fool people into thinking they suddenly have become wealthier (and conversely for surpluses). Is it desirable to influence the path of the economy by using a policy that is effective only because it deliberately misleads the public? Such a proposition seems difficult to justify. Another problem is that any desirable effects are accompanied by other effects that might not be deemed desirable. When equivalence is incomplete, changing the stock of debt outstanding also changes the interest rate in the same direction. In particular, running a deficit in a recession would raise interest rates, which would reduce investment and economic growth, which in turn would reduce output in the future. Thus, using deficits to stimulate the economy now to ameliorate a recession comes at the cost of reducing output later. Whether that is a good exchange is not obvious and requires justification. About the Author John Seater is a professor of economics in the College of Management at North Carolina State University and a Sloan Fellow of the Wharton Financial Institutions Center of the University of Pennsylvania. He was formerly a senior economist in the Research Department of the Federal Reserve Bank of Philadelphia. Further Reading   Barro, Robert J. “The Ricardian Approach to Budget Deficits.” Journal of Economic Perspectives 3 (Spring 1989): 37-54. Butkiewicz, James L. “The Market Value of Outstanding Government Debt: Comment.” Journal of Monetary Economics 11 (May 1983): 373-379. Cox, W. Michael. “The Behavior of Treasury Securities: Monthly, 1942-1984.” Journal of Monetary Economics 16 (September 1985): 227-240. Eisner, Robert. “Budget Deficits: Rhetoric and Reality.” Journal of Economic Perspectives 3 (Spring 1989): 73-93. Ricciuti, Roberto. “Assessing Ricardian Equivalence.” Journal of Economic Surveys 17 (February 2003): 55-78. Seater, John J. “The Market Value of Outstanding Government Debt, 1919-1975.” Journal of Monetary Economics 8 (July 1981): 85-101. Seater, John J. “Ricardian Equivalence.” Journal of Economic Literature 31 (March 1993): 142-190.   (0 COMMENTS)

The gold standard was a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price. England adopted a de facto gold standard in 1717 after the master of the mint, Sir Isaac Newton, overvalued the guinea in terms of silver, and formally adopted the gold standard in 1819. The United States, though formally on a bimetallic (gold and silver) standard, switched to gold de facto in 1834 and de jure in 1900 when Congress passed the Gold Standard Act. In 1834, the United States fixed the price of gold at $20.67 per ounce, where it remained until 1933. Other major countries joined the gold standard in the 1870s. The period from 1880 to 1914 is known as the classical gold standard. During that time, the majority of countries adhered (in varying degrees) to gold. It was also a period of unprecedented economic growth with relatively free trade in goods, labor, and capital. The gold standard broke down during World War I, as major belligerents resorted to inflationary finance, and was briefly reinstated from 1925 to 1931 as the Gold Exchange Standard. Under this standard, countries could hold gold or dollars or pounds as reserves, except for the United States and the United Kingdom, which held reserves only in gold. This version broke down in 1931 following Britain’s departure from gold in the face of massive gold and capital outflows. In 1933, President Franklin D. Roosevelt nationalized gold owned by private citizens and abrogated contracts in which payment was specified in gold. Between 1946 and 1971, countries operated under the Bretton Woods system. Under this further modification of the gold standard, most countries settled their international balances in U.S. dollars, but the U.S. government promised to redeem other central banks’ holdings of dollars for gold at a fixed rate of thirty-five dollars per ounce. Persistent U.S. balance-of-payments deficits steadily reduced U.S. gold reserves, however, reducing confidence in the ability of the United States to redeem its currency in gold. Finally, on August 15, 1971, President Richard M. Nixon announced that the United States would no longer redeem currency for gold. This was the final step in abandoning the gold standard. Widespread dissatisfaction with high inflation in the late 1970s and early 1980s brought renewed interest in the gold standard. Although that interest is not strong today, it seems to strengthen every time inflation moves much above 5 percent. This makes sense: whatever other problems there were with the gold standard, persistent inflation was not one of them. Between 1880 and 1914, the period when the United States was on the “classical gold standard,” inflation averaged only 0.1 percent per year. How the Gold Standard Worked The gold standard was a domestic standard regulating the quantity and growth rate of a country’s money supply. Because new production of gold would add only a small fraction to the accumulated stock, and because the authorities guaranteed free convertibility of gold into nongold money, the gold standard ensured that the money supply, and hence the price level, would not vary much. But periodic surges in the world’s gold stock, such as the gold discoveries in Australia and California around 1850, caused price levels to be very unstable in the short run. The gold standard was also an international standard determining the value of a country’s currency in terms of other countries’ currencies. Because adherents to the standard maintained a fixed price for gold, rates of exchange between currencies tied to gold were necessarily fixed. For example, the United States fixed the price of gold at $20.67 per ounce, and Britain fixed the price at £3 17s. 10½ per ounce. Therefore, the exchange rate between dollars and pounds—the “par exchange rate”—necessarily equaled $4.867 per pound. Because exchange rates were fixed, the gold standard caused price levels around the world to move together. This comovement occurred mainly through an automatic balance-of-payments adjustment process called the price-specie-flow mechanism. Here is how the mechanism worked. Suppose that a technological innovation brought about faster real economic growth in the United States. Because the supply of money (gold) essentially was fixed in the short run, U.S. prices fell. Prices of U.S. exports then fell relative to the prices of imports. This caused the British to demand more U.S. exports and Americans to demand fewer imports. A U.S. balance-of-payments surplus was created, causing gold (specie) to flow from the United Kingdom to the United States. The gold inflow increased the U.S. money supply, reversing the initial fall in prices. In the United Kingdom, the gold outflow reduced the money supply and, hence, lowered the price level. The net result was balanced prices among countries. The fixed exchange rate also caused both monetary and