The Region

Interview with Robert Barro

Harvard economist Robert Barro on Ricardian equivalence, inflation targets and the economics of religion, among other topics.

Douglas Clement - Editor, The Region

Published September 1, 2005  |  September 2005 issue

Robert Barro The staircase that leads to Robert Barro's second-floor office at Harvard spirals like a helix; on the wall above these steps hang large photos of renowned Harvard economists. These are giants in the field—Schumpeter, Hansen, Kuznets, Leontief—and as they twist upward, they create much of the genetic structure of modern economic thought.

In the early 1970s, Barro followed this lineage faithfully, publishing several significant papers along Keynesian lines.

But he soon realized that conventional theory was stagnating. To survive, he knew, macroeconomics must evolve.

Barro broke with tradition in 1974 with a powerful critique of Keynesian thought. Deficit spending won't stimulate an economy, he argued, since rational households will simply save more in anticipation of higher future taxes. "There will be no net-wealth effect," he wrote, "and, hence, no effect on aggregate demand or on interest rates of a marginal change in government debt." David Ricardo had hinted at this in 1820, but Barro's rigorous case rocked contemporary macroeconomic thought and added to the theoretical revolution known as rational expectations.

Barro quickly added seminal papers on monetary neutrality—examining how and when monetary policy could have real economic impact—and the role of reputation in central banking—exploring middle ground between full discretion and rigid rule.

With Gary Becker, Barro then developed a landmark economic model of fertility that incorporated intergenerational decision-making. Barro's research on economic growth, currency areas and other topics has been equally important, breaking new ground and often challenging conventional wisdom. His articles are among the most often cited in economics.

As demonstrated in the 1970s, Barro can change course quickly. Current explorations of the economics of religion and the equity premium puzzle are characteristic forays into unexpected territory. But whether his future efforts take an evolutionary step or a revolutionary leap, Barro's body of work has already established its profound value—economics that will shape generations to come.

DEFICIT SPENDING

Region: The Ricardian equivalence hypothesis, which you brought to prominence in 1974, might be taken to suggest that deficit spending isn't inherently harmful since rational people, expecting to pay higher taxes in the future to pay off government debt, will save more, so private savings will balance out the public deficit.

Does that imply that concerns about "irresponsible" levels of debt are unfounded? And is it puzzling to you that the Ricardian equivalence hypothesis isn't a mainstream belief in macroeconomics?

Barro: Let me say first that I think the Ricardian equivalence idea is basically right as a first-order proposition. However, people get confused as to exactly what it says. Before I say what that is, I should mention that, although the proposition is not mainstream in the sense of being fully accepted by most economists, the idea has had tremendous influence on the way economists think about this issue.

Analysis often begins with Ricardian equivalence as a first-order proposition and then goes on to investigate why there are deviations from precise equivalence. Thus, like the Modigliani-Miller theorem on corporate finance, Ricardian equivalence has become a common starting point for the way people think about budget deficits. This situation is vastly different from what it was before the mid 1970s.

To illustrate the potential pitfalls in what Ricardian equivalence says and does not say, one can consider the famous quote attributed to Vice President Cheney to the effect that President Reagan proved that budget deficits don't matter. The Cheney quote is often interpreted to mean that the level of government expenditure does not matter, and that surely is not what Ricardian equivalence says. The Ricardian proposition is about the consequences of paying for a given amount of public expenditure in different ways. Specifically, does it matter—or does it matter a lot—whether the government pays for its spending with current taxes or with current borrowing, which entails higher future taxes?

So, a central part of the proposition is that the amount of public expenditure—today and tomorrow—is being held constant. It's never part of Ricardian equivalence that the level of government expenditure doesn't matter. As [University of Chicago economist] Milton Friedman put it, the costs or benefits of government outlays depend on the amount and nature of what the government spends—there is no free lunch about paying for that spending. So whether you pay for it now or later is secondary.

As a first-order proposition, it is right that it matters little whether you pay for government spending with taxes today or taxes tomorrow, which is basically what a fiscal deficit is. The difference between taxes today and taxes tomorrow is analogous to the difference between paying for spending with an income tax or a sales tax. The method of public finance is an important question, but it is less important than the question of how big the government is and what activities it should carry out. Taxing now versus taxing later is an issue about optimal taxation, that is, a public-finance topic.

This view moves the analysis away from pure Ricardian equivalence to the optimal tax perspective, which brings in the principle of tax smoothing. The idea is that, unless something special is going on in different periods, optimal public finance dictates having tax rates, for example, on consumption or wage income, that are similar from one year to another. You do not want erratic movements in tax rates, because these patterns are highly distorting. From that standpoint, it is not desirable to have a very low tax rate today, financed by a fiscal deficit, followed by much higher tax rates in the future. This tax-smoothing result deviates from Ricardian equivalence, but in a
second-order way, in the same sense that the choice between an income tax and a sales tax is second order but nevertheless significant.

Anyway, since we've talked so much about Ricardian equivalence, you might be interested in an anecdote. In 1973, I had worked out the basic invariance idea. If the government imposed some kind of intergenerational transfer—through fiscal deficits or enlarged Social Security—individuals who were connected through voluntary transfers to members of the next generation would neutralize the government's actions. All that was required was an interior solution for voluntary transfers from parents to children or in the reverse direction.

Well, before I wrote anything, I sat down for a lunch with Fischer Black (famous, of course, for the Black-Scholes options-pricing formula). I took about 20 minutes to go through the whole analysis I had worked out. Fischer said nothing, but listened intently. When I finished, he uttered only one sentence: "Sounds right to me."

Region: I'd like to follow that with an empirical question, if I might. By some measures, U.S. personal savings rates are quite low. What does this say about people's anticipation of having to pay higher taxes in the future?

Barro: National savings rates are not constant over time in the United States, and they are not the same across countries. A lot of variables influence national saving rates. However, economists have not demonstrated empirically for the U.S. or across countries that there is a regular relation between fiscal deficits or the size of the public debt and the level of the national saving rate. The idea that fiscal deficits drive down national saving is often claimed, but it is mainly proof by repetition. No one has actually shown convincingly that the U.S. national saving rate relates in a systematic way to the size of the fiscal deficit or the stock of public debt, both measured in relation to GDP.

I have been thinking about one interesting fact which may relate to the U.S. national saving rate. If you look particularly since the beginning of the 1990s, there has been a tremendous decline in the price of investment goods relative to consumer goods. Some of that is due to computers and some to other improvements in durable equipment. So if you look at the ratio of nominal investment to nominal GDP, currently that ratio, 17 percent, is a little above its average value since 1954; in particular, it rebounded significantly in the recovery since 2003 from the low ratio during the 2001 recession. Anyway, the current investment-GDP ratio is basically normal.

However, because of the relative price changes, the U.S. economy is getting a lot more in terms of real capital goods with a normal ratio of nominal investment to nominal GDP. In this sense, the saving needed to provide for a given amount of real investment is much less than it used to be. My conjecture is that this development might have something to do with the decline in the national saving rate, but I am unsure whether this view is correct. In any event, the decline in the prices of investment goods compared to consumer goods has been pronounced, and this change is important for economic growth.

SOCIAL SECURITY AND MEDICARE/MEDICAID

Region: Social Security and Medicare/ Medicaid are two major government expenditures, of course. Are you concerned about future spending for those programs?

Barro: I should say, in general, that the Bush administration has been a real failure with respect to fiscal discipline, especially during its early years. I mean this with respect to the level of federal expenditure, not about fiscal deficits per se. Particularly in the first term, there was a tendency to increase spending across the board—a very different pattern from most of the Clinton period, although Clinton did become less disciplined at the end of the 1990s. For Bush, I have in mind not so much the added expenditure on national security or the military, which can be justified by the wars in Afghanistan and Iraq and the overall war on terror. My concern is that, across the board on expenditure, there has not been the kind of fiscal discipline that existed in the 1990s.

The expansion of Medicare, in terms of coverage for prescription drugs, is one important aspect of the lack of discipline, and this "generosity" will have long-term adverse consequences for the federal budget. So, although I am not particularly concerned about the current fiscal deficit, I am worried about the growth of federal outlays under Bush.

The presidents who were good on federal spending discipline were, first of all, Reagan, who began in a very different environment, where spending had been rising relative to GDP since the 1950s. Clinton was surprisingly good on spending restraint, though I think much of this discipline came through Treasury Secretary Rubin and reflected fears of fiscal deficits and rising public debt.

Of course, the legacy of deficits and debt came from Reagan and the first President Bush; that is, they involved what economists now call "strategic budget deficits." I think this Reagan-Bush strategy actually worked to promote discipline on the federal spending side in the 1990s. Of course, it would have been different if Clinton had actually managed to pass Hillary Clinton's overly generous health insurance program during his first term.

Unfortunately, the spending discipline coming from fiscal deficits did not seem to work during Bush's first term. Maybe that is because they figured out Ricardian equivalence—that is, that fiscal deficits do not matter (much). In some ways, it's better if Washington pretends that fiscal deficits and public debt are awful even if they really are not.

Anyway, I agree that the longer-term expenditure problems related to Social Security and Medicare are significant. But there is also a broader, short-run problem with regard to federal spending across the board. President Bush really should try vetoing a spending bill sometime.

THE EQUITY PREMIUM PUZZLE

Region: I understand you've made some headway on the equity premium puzzle, the unexplained gap between average returns on stocks and bonds that Rajnish Mehra and Ed Prescott pointed out 20 years ago. Your explanation for the gap, I believe, involves rare events, a suggestion made by [University of Iowa economist] T. A. Rietz in 1988 that was immediately dismissed by Mehra and Prescott.*

Barro: It is certainly fair to say that this insight was in the 1988 paper by Rietz, which I think came out of his Ph.D. thesis. Mehra and Prescott were extremely critical of the Rietz analysis, and I think they managed to convince most people that low-probability disasters were not the key to the equity premium puzzle. But, although I highly value the insights in their original 1985 paper (which Mehra and Prescott like to point out was actually written in 1979), I think the arguments in their 1988 comment on Rietz were incorrect.

I had not thought much about this issue until a few months back—it's not an area that I've worked in. But when I began to study it, it seemed that low-probability disasters could be quite important. And then I found Rietz's paper, which I thought was a great insight, and I have been building on it. Frankly, I think this idea explains a lot. Of course, there is a good deal more to work out, to think about further, but I think his basic insight is correct.

Region: Could you elaborate?

Barro: Well, "rare events" in this context are low probability, large disaster events. As a U.S. example, you think immediately about the Great Depression. However, war has been historically more important for most countries. I have in mind particularly the economic devastation of World Wars I and II for many countries, including much of Western Europe and Japan. From a U.S. perspective, one thinks about the world wars as times of good economic performance, but that outcome is unusual from a global perspective. For the U.S., one has to go back to the devastation of the Civil War in the South to find something comparable.

Suppose that you have potential events with, say, a 1 percent annual probability, where you lose half of your capital stock and GDP. This possibility seems to be enough to get something like the observed equity premium. Moreover, this mechanism has implications for a lot of other variables, not just for the excess of the average return on stocks over the return on government bills. For example, it can explain the very low "risk-free" rate and low expected real interest rates during most U.S. wars back to the Civil War. It can also explain some of the evolution of price-earnings ratios for the U.S. stock market. I am exploring these implications of the model and, by the time this interview comes out in The Region, I will have discussed it at the macroeconomics workshop in Minneapolis [the August 2005 Minnesota Workshop in Macroeconomic Theory, organized by the Minneapolis Fed and the University of Minnesota].

The data are intended to motivate the theoretical framework and to think about how to calibrate the model with reasonable numbers. I've looked at the 20th century history of large, short-term economic contractions as a way of motivating the general orders of magnitude for the parameters in the model.

So, looking at the world wars and the Great Depression, and other depressions—for example, in Latin America and Asia in the post-World War II period—you find a substantial number of these events. If you take that whole history covering many countries over 100 years, you get some idea of the probability and potential size of these rare disasters. I show in the model that if you use these "reasonable" parameters, the theoretical results match up with empirical observations, such as the equity premium.

The equity premium is mostly about the very low risk-free real interest rate. The rare-disasters framework says that this low risk-free rate reflects the large demand for risk-free assets because of the potential for big disasters. In addition, the framework explains how the expected real interest rate on, say, government bills moves around when perceived disaster probabilities change. You do not need very big changes in probabilities to get fairly substantial responses. A small increase in this kind of risk—as an example, due to the September 11th events—leads to a noticeable response of real interest rates. When this probability goes up, the risk—free rate goes down because people put more of a premium on holding a relatively safe asset.

I argue that this approach can explain a lot of the real-interest-rate movements in the U.S. history—particularly why expected real interest rates were very low during the main wartime periods in the United States, including the Civil War, World War I, World War II and the Korean War.

Mehra and Prescott talked about this kind of prediction from Rietz's model, and they dismissed his model because they argued that the predictions were wrong. But I think they were mistaken in the way they applied the model empirically. For example, they inferred—correctly—from Rietz's model that an increase in the perceived probability of a great depression would lower the risk-free real interest rate. But I do not think they correctly isolated time variation in depression probabilities.

For example, they argued that people expected a depression after World War II. Therefore, when no depression arrived, they argued that the probability of a depression must have gone down a lot. They then say that Rietz's model predicts that the real interest rate should have fallen, say, in the 1950s, which it did not. I do not accept the premise here. It is not obvious that anyone except for a few Keynesians anticipated a resumption of the Great Depression in 1947. Thus, I am not persuaded that the time path of perceived depression probabilities followed the one posited by Mehra and Prescott.

A clearer set of events is in the 1930s. First, when you had the Depression starting in the early 1930s, it must be that people raised the probability of having a future depression because they had not seen an economic contraction this big before. But then there was a substantial recovery from 1933 to 1937 in the United States—it is actually a very high growth period. So I would assume that people would have gotten more confident and lowered their perceived probability of a return to depression.

But the most striking event in this story is the big recession in
1937-1938. I think that event must have raised the perceived probability that we were going back into a depression. It was quite a large contraction. I think that period provides a much cleaner experiment than Mehra and Prescott's post-World War II scenario in terms of time variations in the probability of depression.

I was also looking at the time series of perceived probabilities of war to get further predictions about real interest rates and other variables.

Region: Where will you take this research from here?

Barro: I'm trying to get more objective measures of disaster probabilities by using options prices on the stock market. Insurance contracts might be revealing about disasters on which contracts were written. More recently, some of the Internet betting markets are interesting because some of the events look like crises, such as China attacking Taiwan or North Korea exploding a bomb. I don't know if I can get enough consistent data from the betting markets to get a full picture, but some of it looks suggestive. Probably the best idea is to look at far-out-of-the-money put options on a broad stock-market index. This contract is basically a bet about the likelihood of economic disaster.

INFLATION TARGETING

Region: Your research on rules, discretion and reputation in central banking has been very influential on monetary policy theory and practice. What is your view of inflation targeting? And a related question, I think: You recently wrote a BusinessWeek column suggesting that we might be able to "channel" Chairman Greenspan in the future. Could you elaborate on that?

Barro: The change in monetary policy over the last 20 years or so has been a tremendous success in the United States and other advanced countries. It's been a tremendous change compared to what we were going through in the 1970s and early 1980s.

In a general sense, there has been a shift toward the idea that the monetary authority should be committed to something like price stability or inflation targeting. This general idea has been pretty well accepted. Central banks have also gotten technically more proficient at controlling short-term nominal interest rates and adjusting them in response, particularly, to inflation.

In the United States, the watershed period was when Paul Volcker was in charge. The inflation rate shot up like crazy at the end of the 1970s, into the early 1980s. Volcker's committed policy with very high interest rates brought down inflation—I think that was the key event.

Region: Was Volcker essentially creating reputation, in the sense of your 1983 paper with David Gordon?

Barro: There were a couple of things there. Volcker was establishing the credibility and commitment to bringing down inflation. Secondly, there was the more technical point that driving up nominal interest rates actually worked. Since 1987, Alan Greenspan has done a fine job as Fed chair, by following through successfully on the course set out by Volcker.

I think over the last two decades the Fed has come close to an inflation targeting regime even though it's not explicit. If you study the federal funds rate, you can explain most of the movements, say, since 1987, with a fairly simple relationship based mostly on inflation and labor-market conditions. When employment growth is strong and the unemployment rate is low, the Fed tends to raise rates. When the inflation rate is high, they tend to raise rates.

Region: Is the relationship you have in mind here similar to a Taylor rule?

Barro: Yes, it looks like that, but there are some differences. For example, it's clearly not GDP that the Fed reacts to. Given what's going on in the labor market in the sense of employment growth and the unemployment rate, empirically there's no reaction of the federal funds rate to GDP growth. Hence, when GDP growth goes up because of higher productivity growth, there's no tendency to raise the federal funds rate.

But if the economy is strong in terms of a tight labor market, meaning higher employment growth and a low unemployment rate, there seems very regularly to be an upward movement of interest rates. The reverse holds when the labor market is weak.

On the inflation side, it's a broad inflation index that seems to influence the Fed—something like the GDP deflator or the deflator for personal consumption expenditures. The Fed does not seem to react on a month-to-month basis to the consumer price index or the producer price index. So, in a general sense, it's a Taylor rule but it has some features that differ from [Stanford University's] John Taylor's precise formulation.

A crucial feature is that monetary policy responds to the economy in a way that's particularly strong with respect to inflation. The idea is that when you bring the [federal] funds rate up, inflation is supposed to go down. This mechanism has worked much better than I would have predicted at the end of the 1970s and early 1980s—it's kind of amazing how well this has turned out, and not just in the United States. Many other countries have gone further in terms of formalizing this policy reaction into a rule. I think the more formal rule is a good idea. I'm not sure it's that important because the United States is pretty close to it anyway. However, if Ben Bernanke becomes head of the Fed, he will likely try to implement something that looks more like a formal rule.

Region: "Constrained discretion" is a term he's used.

Barro: Yes. Whereas if it's Marty Feldstein [of Harvard University] or Glenn Hubbard [of Columbia University], I think they would be less inclined to formalize the procedure. I am not sure how critical that is. Particularly given that we have these 20 years of strong performance and a general idea of what that involves, I do not think we will get into the kind of inflation troubles we had in the 1960s and 1970s.

But I can see the argument why it might be better to have formalized inflation targeting, first as a guide as to what to do and secondly as a formal procedure. It's also true that some central banks have become technically better than others at actually targeting interest rates in terms of how much they move around from day to day. But I don't know that this precision is all that important. The more general idea of responding to inflation with high short-term interest rates is more important than the details.

EUROPE'S MONETARY UNION

Region: You've conducted research with [Harvard economist] Alberto Alesina on optimal currency areas. What's your viewpoint on the struggles that the Economic and Monetary Union is having with its Stability and Growth Pact?

Barro: I think the European monetary union or common currency is a good idea. The free trade area earlier was also a good idea. But I think it's a big mistake to be extending the integration to try to have more of a political union and a union that covers almost everything, including fiscal and social policies and regulations. That's why, from the standpoint of the United Kingdom, even though it would be attractive to be on the euro, I don't think it's worth it in terms of all the rest of the baggage that they would get from the Continent. The burden on the U.K. would be particularly great in terms of social policies and labor market regulations. And I don't think they can avoid these "side effects" from joining the monetary union; unfortunately, it's all part of the package.

But the monetary union itself is very positive in terms of promoting trade and financial flows. On the fiscal side, it's not clear to me why you want to have a centralized setup. It's important that individual countries have responsibility for their own public debts and their own tax systems. It would, of course, be problematic if the central government were bailing out individual countries who incurred excessive debts. Take an example like Argentina. One problem there was that individual states could incur debts and basically make these debts obligations of the central government. The incentives for fiscal irresponsibility were obviously great and tended to promote excess spending at the state level.

The analog in the euro zone would be if the center assumed liability for the debts of individual member states—that would be disastrous. However, that situation fortunately does not apply. Therefore, I see no rationale for the fiscal pact, with features such as the 3 percent of GDP limit on fiscal deficits. In any event, this fiscal pact has now broken apart. I think this breakdown is OK. The Europeans should shift to a much more modest form of union—a monetary union and a trade union—and forget about the rest of it.

ECONOMICS OF RELIGION

Region: Most economists will not expound on religion, considering it outside the purview of economics. You're an exception to that rule. In your work with your wife [Harvard scholar] Rachel McCleary on the associations between religion and growth, you're trying to tease out not just correlations but causality. Can you tell us what you've found?

Barro: I'm excited about this research project. It's on the interplay between religion and political economy, so there's a two-sided interplay here. One is about religion having influence on beliefs, values, traits like honesty, work ethic, thrift and so on—the kinds of things that Max Weber looked at. In this context, we are studying the impact of religion on economic growth and productivity, and also on political institutions, including democracy. These effects represent one direction of causation.

The other effect, a big part of the literature on the sociology of religion, is that economic development and government policies influence the levels of religiosity in society. For example, one idea is that as nations get richer and better educated, they tend to become less religious.

Region: The "secularization" of society?

Barro: That's the secularization hypothesis, exactly. And though that hypothesis has lost favor, I think the empirical evidence supports it. Religion is not disappearing, but economic development does tend to reduce religiosity measured in various ways. A related idea is that what governments do in terms of having official state religions or regulating the market—either subsidizing or suppressing religion—has an impact. Communist countries were particularly focused on antireligion policies, at least for usual kinds of religion—that is, if we do not count communism as its own religion.

In terms of economists' attitudes, it certainly was true in the past that there was a lot of resistance to anything that looked fluffy, like culture. There may also have existed an antireligion theme more specifically. But I think these attitudes are changing. Recently there has been increasing interest among economists in the economics of religion. Some of this research interacts with work by sociologists, who traditionally spent considerable effort on the sociology of religion. There is an expanding group of people who are trying to combine social science with religion. Quite a few well-known economists are now in this group.

Region: Could you explain your concept of "religious capital"?

Barro: The general idea is analogous to investing in education to accumulate human capital. Or, alternatively, one can think of investing in networks and friendships to form social capital. Analogously, you can invest in spirituality and beliefs to form a kind of religion capital. Rachel and I think of this influence as working through beliefs, not so much through networking, or going to church and meeting lots of people. That would be more like social capital. We do not find that channel to be important—church is not just another form of social club. (And, by the way, I know of no serious evidence that social capital is an important determinant of economic growth.)

We think that religion is most influential because it affects certain kinds of beliefs—beliefs in an afterlife, believing in hell and heaven and so on. These beliefs matter, along the lines of Weber, if they support certain traits and values, such as honesty, work ethic, thrift and hospitality to strangers. These traits then influence productivity and work effort, which ultimately affect economic growth.

This approach accords in a general way with Weber's thinking about how certain religious differences mattered for economic development. His focus was on an early point of the development of capitalism in Western Europe. Weber thought that this influence was only important in the early stages of industrialization, particularly in comparing Protestant and Catholic countries in Western Europe. He didn't think it was significant later in the 19th century, when he thought much of the underlying traits and values had been incorporated into governments and other secular institutions. So I'm a little unsure what Weber would think about our own research. Obviously, we're looking at modern data, mostly 20th century data. And I'm not sure what he would think about our detailed quantitative research.

The other thing I might mention is that I find that whenever I give a seminar on this topic, I inevitably get a question about whether I'm personally religious. The attitude seems to be that if I'm studying this topic it must come from some individual set of beliefs or commitment to a particular religion.

It's curious because people studying other aspects of social science do not tend to get analogous questions. [University of Chicago economist] Gary Becker studied the economics of crime, and (as far as I know) nobody ever asked him if he was a criminal or had a lot of criminal experience. But somehow the analogous question with respect to religion almost always comes up. It might relate to what you said earlier, about how economists are still reluctant to study this topic, and therefore they conclude if somebody is studying it, it must be from some personal motive, rather than from detached scientific inquiry. One can think that religion is a major social force—as it surely is—even if one is not personally religious.

Region: If I'm not mistaken, Gary Becker got his idea about crime and economics when he was thinking about parking illegally.

Barro: George Stigler had a wonderful photo of Milton Friedman getting a speeding ticket on Lake Shore Drive in Chicago. It's a classic photo.

Region: Friedman, the most influential economist of our time, didn't talk his way out of it?

Barro: No, I don't think so. The idea was that Friedman must have been optimizing. Even though he got caught and received a speeding ticket, the probability of apprehension was not too high, ex ante, and the time saving made it worthwhile.

ECONOMIC GROWTH

Region: I'd like to ask you more broadly about the issue of economic growth. Since the work on growth models in the '50s and '60s, and then endogenous growth theory later on, it seems that economists more recently have been engaged in empirical analysis, trying to figure out the relative levels of influence of technology, human capital, geography, institutions—"do institutions rule?" is the phrase often used here at Harvard—or even culture, on economic growth. You've done important empirical analysis of this sort. Where do your sympathies lie? What seems most powerful?

Barro: In contrast to the work on the neoclassical growth model in the 1950s and 1960s, the later growth theory, such as [Stanford University economist] Paul Romer's at the end of the 1980s and early 1990s, was followed up with empirical inquiry. The irony is that a good deal of the empirical work, such as work I did starting in the early 1990s, had more to do with the basic neoclassical model. That perspective surely applies to the convergence hypothesis, which is an important part of the empirical work of the early 1990s. Most of the empirical work has been less closely tied to the Romer style theory, which stressed the roles of ideas and endogenous technological progress. In other words, a lot of the 1990s empirical work could have been done in the 1960s because many of the implications being tested really come naturally out of the basic Solow growth model. I don't know why that empirical work didn't happen 25 years earlier.

Some interesting recent empirical research has been on the formation and influence of institutions. This work ties in with an emphasis more generally on political economy, research that was also important in the 1990s and continues to flourish. I think it's right that institutions, rule of law, corruption and so on are important factors for determining economic growth. Even the World Bank now thinks that these issues are central.

INEQUALITY AND GROWTH

Region: What have you discovered in your research on the relationship between inequality and economic growth?

Barro: I did not find an important, systematic effect of income inequality on economic growth. And theoretically it can go in either direction. I found some indication of second-order effects if one distinguished the role of inequality in poor countries from that in rich countries.

The Kuznets curve refers to the reverse direction of effect—the idea that, as a country develops, there will be a hump-shaped relation—initially, inequality goes up and later it goes down. There is a little evidence to support the existence of this Kuznets curve, but the evidence is not that powerful.

You can see the Kuznets relation in China. Inequality went up a lot because certain urban areas have been doing especially well. Rural agriculture, although performing better than under the previous regime (which really was communist), has not done as well as the urban areas. So that means inequality increased in China at the same time that per capita GDP went way up and poverty went way down.

You would anticipate that, as China continues to grow, it will also integrate more fully the poorer rural sections of society with the advanced urban ones. Enhanced mobility from rural to urban areas is part of this process. This dynamic should generate a classic Kuznets curve, with an inverted-U relationship between income inequality and the level of per capita GDP.

THE FUTURE OF MACRO

Region: In the early 1970s, I believe, you told Gary Becker that you thought macroeconomics was stagnating and you thought you might get into microeconomics.

Barro: Right.

Region: And then rational expectations swept the field, and you were one of the pioneers in that revolution. Bearing in mind your past forecast, what would you say about macroeconomics today? What do you think are promising areas for research in macro now? And are you still thinking of going micro?

Barro: I was clearly a very bad predictor in the early 1970s of how macroeconomics would evolve. I think I was particularly influenced at that time by Keynesian macroeconomics, which I had been working on, and I think I was accurate in seeing that field as not having great potential.

But, as you've suggested, shortly after I said that macroeconomics was not promising, there was an amazing sequence of exciting developments. It started with the rational expectations work—applied initially to monetary models with some version of a Phillips curve. And then there was the real business cycle analysis that Prescott particularly pioneered. Then you had the very exciting work on economic growth, with growth viewed more and more as a core part of macroeconomics. Then there was the pretty much distinct empirical work on economic growth. So this was a whole sequence of, you could say, four different exciting developments in macroeconomics after I said it was stagnating.

Now it does seem that perhaps the last 10 years or so have been less exciting in comparison. It's been a while since we have seen something equivalent to those four breakthroughs.

There has been progress, even on the Keynesian side. We now have more sophisticated approaches to sticky-price models. Some of this research relates, at least in terms of ex post explaining, to the great real-world success on monetary policy. However, you might also date these advances to the 1980s, so this does not change my sour perspective on recent developments.

There has, however, been the political economy research discussed before and the applications of this work to institutions and growth.

Region: If things are stagnating, perhaps another revolution is in the offing.

Barro: Well, it's the essence of a revolution that it has to be unpredictable, right? If you could have predicted it in advance, it would have already happened.

Region: How does economics advance—is it evolutionary or revolutionary?

Barro: I think there are major events that look like discrete changes, followed by a period of more evolutionary developments, refining and extending.

Region: Are you going to go micro?

Barro: I've always had a great interest in applied micro, so often when I write a column for BusinessWeek or The Wall Street Journal it's along those lines, even though [their] editors always want me to talk about macroeconomics, including monetary policy. I like to do applied micro columns, maybe because my research is not so much on that. And I think two of my most popular columns were on "economics of beauty" and "economics of drug legalization," two clearly micro topics.

I'm not sure why I got into macroeconomics in the first place, except that I started there. In fact, my first economics course used Keynes' General Theory as a textbook. In some ways, I like the applied micro topics better. However, macroeconomics usually deals with larger, more important issues.

THE IMF

Region: The International Monetary Fund came under severe criticism in the 1990s, but in recent years it has undergone substantial reform. I think even Allan Meltzer [of Carnegie Mellon University and head of an IMF reform commission in 2000] is fairly content with the improved IMF. But not you. Some of your research indicates that countries that take IMF loans or are involved in IMF lending programs do more poorly in terms of economic growth, in terms of rule of law and democracy. Would you tell us about that work?

Barro: Recently there has been a lot of discussion about debt relief, foreign aid, the role of the World Bank, as well as IMF programs. I think these are all basically analogous in terms of their impacts. As an example, the problems with the IMF are not technical issues about specific decisions and whether their staff is competent. The problems are embedded in the nature of the institution. By design, the setup has to encourage moral hazard; it has to encourage poor behavior on the part of the potential and actual recipients. I once suggested that they change the name to IMH for Institute of Moral Hazard, instead of IMF [laughter]. I guess that suggestion wasn't taken too seriously.

I'm often asked by government policymakers what the IMF should do better or how it should be reformed, and I think there's no answer to that—other than going out of business. That's why I thought Allan Meltzer basically caved in when he was running that [reform] commission; they were essentially co-opted, I think, in terms of proposing a detailed set of reforms. The IMF is very happy to receive these kinds of detailed proposals, which basically accept the central rationale for the institution and keep them in business. But I think this kind of reform process is inherently hopeless.

It's in the institution. It's in the structure. It's in the incentives. Of course, the IMF has also become over time more like the World Bank, in terms of getting increasingly into the business of foreign aid and long-term development assistance, as opposed to the shorter-run stabilization loans that were the original concept. The World Bank and the foreign aid process have even more of these moral hazard problems, and the IMF is increasingly getting into that business.

In our detailed research, [Korea University economist] Jong-Wha Lee and I found that the impact of the IMF on economic growth looked even worse when you took a broader view to include all their loan programs—which recently have included more long-term development assistance to poor countries—than if you limited the sample to the short-run stabilization loans that tend to go more to middle- and upper-middle-income economies.

Region: Could that be a selection issue, since troubled countries are more likely to seek assistance?

Barro: Yes, the central thing we worried about in our research was the selection issue. IMF people often say that it's not fair to blame them because they're around when there's a crisis. They say that they were called in, like a doctor, to treat an emergency. And that's a very fair point. So the essence of our empirical work is to try to get something equivalent to an experiment where the IMF comes in for reasons other than the fact that the country is doing badly. That is the essence of the research project that we're doing on the IMF.

We came up with ways to isolate the exogenous part of what the IMF was doing, and we still found that on net it looked bad. The same selection issues arise with foreign aid, because aid usually goes to countries in trouble. Somehow you have to take this "endogeneity issue" into account. More recently we have as another example the grand project of debt relief—again a form of intervention that tends to apply to countries in trouble.

There is a common element in all these areas—they all look like money for nothing. And I don't think money for nothing is the way to get economic development. That's why even though I like [Irish rock star] Bono—I think he's very smart, a well-meaning person, and he's amazingly influential—I think his whole project of debt relief is so woefully misguided. This well-meaning assistance will not be the way to get poor African countries to do better.

Region: So you and [Columbia University economist] Jeff Sachs don't see eye-to-eye?

Barro: We had a wonderful lunch back in 1999—Sachs, Bono and I. It was clear that they invited me not to get information or advice. Instead, Bono wanted to learn the conservative, free-market objections to his approach so that he could come up with better counterarguments. Then he could be more persuasive, as he turned out to be, even with Republican officials in Washington. I'm sure I had no impact on the policies that Bono ended up proposing. It's amazing what kind of influence he's had. He really did manage to convince many people in Washington to carry out substantial debt relief. It's a shame that we could not harness his talents for persuasion in more productive directions.

Region: Thank you very much.

* In a 1988 Journal of Monetary Economics article, Rietz wrote, "Risk-averse equity owners demand a high return to compensate for the extreme losses they may incur during an unlikely, but severe, market crash." Mehra and Prescott rejected this explanation in the same issue of JME.

More About Robert J. Barro

Current Positions

Paul M. Warburg Professor of Economics, Harvard University, where he has taught since 1987

Senior Fellow, Hoover Institution, Stanford University, since 1995

Research Associate, National Bureau of Economic Research, since 1978

Previous Positions

Distinguished Professor of Arts and Sciences, University of Rochester, 1984-87; John Munro Professor of Economics, 1978-82; Professor, 1975-78

Professor of Economics, University of Chicago, 1982-84; Associate Professor, 1973-75

Associate Professor of Economics, Brown University, 1972-73; Assistant Professor, 1968-72

Major Professional Activities

President, Western Economic Association, 2005

Co-editor, Quarterly Journal of Economics, since 2004

Viewpoint columnist, BusinessWeek, since 1998

Vice President, American Economic Association, 1998

Academic Advisory Committee, Wuhan University, China, since 2002

Member, Mont Pelerin Society, since 1990

Academic Advisory Board, Universidad del CEMA, Argentina, since 2000

Advisory Board, Fundacion Libertad, Argentina, since 1999

Board of Economic Advisers, Universitat Pampeu Fabra, Barcelona, since 1997

Advisory Board, University of Science and Technology, Hong Kong, since 1996

Awards and Honors

Honorary professorship, Tsinghua University, China, June 2005

Harris Distinguished Visiting Professor, Clemson University, 2004

Honorary degree, University of Macedonia, Greece, 2004

Honorary professorship, Wuhan University, China, 2003; Seoul National University, South Korea, 2003

Essential Science Indicators, named most cited economist of the 1990s, August 2001

Fellow, American Academy of Arts and Sciences, since 1988

Fellow, Econometric Society, since 1980

Recent Books

Macroeconomics: A Modern Approach, forthcoming from Thomson Learning

Economic Growth, 1st ed., McGraw-Hill, 1995; 2nd ed., MIT Press, 2004 (with Xavier Sala-i-Martin)

Nothing Is Sacred: Economic Ideas for the New Millennium, MIT Press, 2002

Education

Doctorate in economics, Harvard University, 1970

Bachelor's degree in physics, California Institute of Technology, 1965


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