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Reviews treatment of an old standard, not an entirely new standard. Zerbe, for instance, does not suggest that the old Kaldor–Hicks standard was not essentially concerned with measuring preferences, even if it was ostensibly to do with utility. Nor does he move away from the idea that a kind of subjective benefit-cost analysis is required, even if he thinks it could be done better. Nor, finally, does he jettison willingness to pay (which depends in turn on ability to pay) as the ultimate arbiter of preferences. As such, the so-called KHZ standard still falls short of providing an accurate measure of preferences, let alone utility or, for that matter, distributive justice. That has been a real problem with the Kaldor–Hicks standard, as many of its critics and even its supporters have pointed out before (see, for instance, Trebilcock 1999). It may be that willingness to pay is the best way we have of measuring preferences in many contexts: other methods are worse. But it still, as Ronald Dworkin put it (Dworkin 1980), represents a ‘false target’ for anything of value, and a poor one at that. Zerbe’s response is that, to the extent concerns about the willingness to pay measure are reflected in social norms of the community, or at least of those who are willing to pay for their preferences to be acknowledged, there is a way of tying them into the KHZ standard. They can be considered along with other benefits and costs associated with a given change, as subjectively assessed. But the analysis provides a very limited basis for accounting for social norms. Further, in the same way as lawyer economists have learnt that legal standards may affect social norms, so may efficiency standards. The concern is that a degree of complacency may emerge around an efficiency standard that relies on willingness (and ability) to pay and that this will be reflected in the preferences of those whose preferences can be counted. Ultimately, there seems to me to be no way out of the conundrum except to acknowledge that efficiency based on Kaldor–Hicks (including KHZ) is not the only standard to be employed when choices have social implications. We can still argue separately about distributive justice, though even here social norms may not provide the best measure of what is the just solution. Further, our current attempts to measure efficiency should be viewed with a degree of scepticism. It is true we are yet to see a practical alternative to Kaldor–

Economic Efficiency in Law and Economics, by Richard O. Zerbe Jr (Edward Elgar, Cheltenham UK, 2001), pp. 333. Richard O. Zerbe’s Economic Efficiency in Law and Economics is one of many books recently published about law and economics. In fact, the book really is only marginally concerned with the law. It has a lot more to do with economic philosophy. In particular, it is concerned with addressing some of the perceived difficulties with the Pareto and Kaldor–Hicks standards that most of us have come to accept as the base-lines for measuring efficiency. The central tenet of the book is that, if a better efficiency standard could be devised, one that more accurately measured preferences and more fully acknowledged the social importance of distributional outcomes, this would make for better decision-making for overall social benefit. So, much of the book is concerned with criticising the Pareto and Kaldor–Hicks efficiency standards (mainly drawing here on critiques of others) and then coming up with a new standard, modestly termed ‘KHZ’. Zerbe’s KHZ standard explicitly adopts preferences as its benchmark, not ‘utility’ as under the old Kaldor–Hicks standard. Zerbe acknowledges that transaction costs and social norms (the latter reflected in subjective assessments about benefits and costs) need to be considered in a full appraisal of preferences. Therefore, account can be taken of social attitudes about the distributional effects of a given change. And it is allowed that the effects of legal rules cannot be treated as irrelevant in any rational assessment of benefits and costs since these add to transaction costs if legal property rights are being appropriated. Beyond that legal rules will be reflected in subjective assessments about benefits and costs, to the extent they are embedded in social norms. Zerbe offers a sophisticated and pragmatic treatment of the Kaldor–Hicks standard that may appeal to anyone with an interest in public policy. From a lawyer’s perspective the treatment is valuable in its acknowledgement of the binding effect of legal obligations and the, often close, relationship between legal standards and the social norms of the community whose preferences are being assessed. It is debatable whether the label ‘KHZ’ should be applied when all that is being offered is a new

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Hicks efficiency (which can apply outside the narrow parameters dictated by the Pareto standard). But in my view it is better to strive to measure preferences properly, or at least acknowledge that our existing measures are imperfect but the best we have for the moment, than to maintain the fiction that a standard that takes willingness (and ability) to pay as its measure is accurate in recording preferences. In fact, I would go further and argue that it is wrong to focus exclusively on preferences. An efficiency analysis should always ultimately be concerned with utility (in the objective sense) not simply subjective preferences, even if preferences are an important part of assessing utility. Otherwise there is no basis left for considering whether what someone may prefer is socially desirable. Economic Efficiency in Law and Economics is an interesting and worthwhile book. If I have disagreed with some of its premises, it still offers much of value for those inclined to look more closely at the Kaldor–Hicks standard and its relevance to public policy decision-making. Hopefully, in the future we will see some economist– philosophers providing a better solution still to the problem of measuring utility. REFERENCES Dworkin, R. (1980), ‘Is Wealth a Value?’, Journal of Legal Studies 9, 191. Trebilcock, M. (1999), ‘The Value and Limits of Law and Economics’, in M. Richardson and G. Hadfield, (eds), The Second Wave of Law and Economics, Federation Press, Sydney.

MEGAN RICHARDSON The University of Melbourne

Debunking Economics: The Naked Emperor of the Social Sciences, by Steve Keen (Pluto Press, Sydney, 2001), pp. xvi + 336. As Steve Keen observes, this is far from the first book to attack the validity of economics, and it is unlikely to be the last. Similarly, this is not the first review of such a book, and surely not the last. Some points are more or less inevitable in such a review, so I will make them as briefly as possible before moving on. First, critiques are, by nature, stronger in attacking existing orthodoxy than in presenting alternatives. Secondly, most criticisms

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are not entirely new, and the proponents of orthodoxy usually have some sort of response. Third, the version of orthodoxy presented in a critique will almost always be a little out-of-date and something of a caricature. Keen’s book will no doubt generate all of these responses, but it is, nonetheless, well worth reading. Although he is not absolutely consistent on this point, Keen generally uses the term ‘economics’ to refer to the simplified version of neoclassical economics taught to first year undergraduates and the associated set of prejudices in favour of free-market economic policies. As Keen correctly observes, this is all the economics that most students ever get, in part because economics is provided as a service course for business and accounting students and in part because the difficult, abstract and apparently irrelevant nature of the material turns many students off the subject. If asked, many of these students would no doubt say that the subject is ‘too mathematical’, and many critiques of mainstream economics reinforce such prejudices with cheap shots against mathematical methods. While effective with their target audience, such attacks are inevitably dismissed as the product of ignorance or intellectual envy by economists who have mastered mathematical methods. To his credit, Keen avoids this easy line. At the risk of limiting his readership he presents his arguments in a form at least as rigorous as, and often more rigorous than, that of the introductory texts he is attacking. Since Keen lists Fisher, Hicks, Samuelson, Solow and Stiglitz as mainstream economists who have to some extent distanced themselves from ‘conventional economics’ it seems reasonable to narrow the target further and to say that Keen’s critique is aimed at what is commonly called the ‘Chicago school’. Although by no means dominant among academic economists, it is fair to say that the ideas of the Chicago school inform the thinking of most of the ‘market economists’ who appear on our television screens. The first part of the book consists of a series of arguments to the effect that the foundations of economics are intellectually unsound. Unfortunately, Keen leads off with his weakest punch, based on the observation that it is not, in general, possible to derive an aggregate demand curve of the type presented in introductory textbooks. Keen gives a very clear exposition of the derivation of an individual demand curve and an

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intuitive demonstration of the point that individual demands can only be aggregated in the case of identical preferences of Gorman polar form. This naturally leads up to the rhetorical question: So What? Keen answers this question with the claim that ‘it matters because economists are trying to prove that a market economy necessarily maximises social welfare. If they can’t prove that the market demand falls smoothly as price rises, they can’t prove that the market maximises social welfare’. This is simply wrong. The standard proof that the market maximises social welfare (more precisely, that, in the absence of externalities and so on, a competitive equilibrium is Pareto-optimal) is based on the general equilibrium theory of Arrow and Debreu. This theory does not rely on demand curves or representative agents. In fact, heterogeneity among agents increases the potential gains from trade and therefore the welfare benefits of a market economy. Keen is on stronger ground with his observations on economies of scale and natural monopoly, a topic that is usually glossed over in introductory presentations of economics and has only recently begun to receive serious attention from mainstream economists. Keen observes that the unwillingness of the half-trained economists who formulate most public policy to accept notions of natural monopoly has led to absurdities such as the rollout of duplicate optical fibre cables to half the country with no service at all for the other half. Keen draws the conclusion that ‘the proper manner in which the issue of ‘‘monopoly versus competition’’ should be approached is on a caseby-case basis, where the merits of one form or the other of organising production can be dispassionately considered. The instinctive economic bias against monopoly should be replaced by something more intelligent’. This sensible conclusion is consistent with the views of the majority of mainstream economists who accept that the conditions for a competitive equilibrium are frequently violated in reality. As such, it constitutes a useful corrective to some widespread prejudices, but scarcely a knockout blow for economics. Keen also provides a critique, in two parts, of the marginal productivity theory of distribution. The discussion of labour markets will shake the faith of those whose knowledge of the subject begins and ends with J B Clark, but, apart from some polemical asides, is not that much different from that presented in mainstream labour

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economics texts (at least, those not overly influenced by Chicago). The chapter entitled ‘The Holy War over Capital’ is a summary of the Cambridge capital controversy (naturally, from the UK side). As with the consumer aggregation problem, the rhetorical question ‘So What’ is asked, but not effectively answered. The fact that aggregates like ‘capital’ and ‘profit’ are not, in general, welldefined is, as Keen observes, a big problem for Marxism, but it is essentially irrelevant for neoclassical economics. Keen follows up with chapters on methodology, the failure of attempts to produce a genuinely dynamic version of neoclassical economics and the Keynesian critique of Walrasian equilibrium theory. This is relatively well-trodden ground, and Keen gives a good summary of the standard critiques of orthodoxy. Of more interest in the current economic environment is a pair of chapters on asset markets. The first is focused on Fisher’s debtdeflation theory of depressions which, as Keen observes, has been neglected by comparison with his strictly neoclassical theory of interest. Keen also presents the ideas of Keynesian theorists of financial instability such as the late Hyman Minsky. On the other hand, recent mainstream work on asset market overshooting and price bubbles, such as that of Shiller, is not discussed. While these ideas have been discussed for some time, they are given added force by the magnitude of the financial bubble in the United States that is still in the process of deflating. Although the economics profession has yet to digest this episode, it is difficult to see how the efficient markets hypothesis can survive the observation of ludicrous asset valuations being formed in the most sophisticated and well-developed financial markets the world has ever seen. Finally, Keen turns his attention to possible alternatives. Classical Marxism gets short shrift mainly because of the labour theory of value, which Keen correctly regards as a dead end. He gives a brief but sympathetic exposition of the ideas of the Austrian, post-Keynesian, Sraffian, complexity-theoretic and evolutionary schools, but admits that ‘none of these is at present strong enough or complete enough to declare itself a contender for the title of ‘‘the’’ economic theory of the 21st Century’. Keen gives little attention to developments within the mainstream. During the last 30 years

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however, there have been important developments in such areas as modelling of hysteresis, theories of asymmetric information and the analysis of increasing returns to scale. These internal developments have done more to undermine the simplistic certitudes of the first-year textbooks than any external critique. If we accept both Keen’s view that mainstream economics is an emperor with no clothes and his assessment that there is, as yet, no adequate alternative, our prospects for understanding the issues that dominate much of our lives seem bleak. However, while Keen has made some important critical points, his claim to have ‘debunked’ economics seems premature. On the whole, the most promising response to the problems identified by Keen would seem to be the continued development of more sophisticated and realistic approaches to mainstream economics, and the cultivation of an openminded and skeptical view of the world, in which economic theories are seen as tools to aid understanding rather than as bodies of received revelation. JOHN QUIGGIN Australian National University

Global Trade and Conflicting National Interests, by Ralph E. Gomory and William J. Baumol, with a contribution by Edward N. Wolff (MIT Press, Cambridge USA, 2000), pp. xvi + 199. It is rare, if not unprecedented, for two worldclass scholars who are not trade theorists – one mathematician (Ralph E. Gomory) and one economist (William J. Baumol) – to co-author a book on international trade. This is an opportunity for us to see how these ‘outsiders’ view and contribute to international trade theory. Their book, Global Trade and Conflicting National Interests, satisfies our curiosity in this regard. More importantly, this book makes a valuable contribution to the literature on international trade. It is also a book that will interest non-specialists as well as international economists. The central message from this book is very clear: ‘under modern free-trade conditions, there is no longer one, but rather many possible freetrade outcomes, and a country is better off with some than with others’ (p. viii).

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Before the late 1970s, the field of international trade was dominated by classical models based on decreasing (or constant) returns to scale and perfect competition. Born in the late 1970s, rapidly developed in the 1980s and matured in the 1990s, the new trade theory is built on the premises of increasing returns to scale and imperfect competition. The literature of the new trade theory has been comprehensively reviewed, first by Helpman (1984) and more recently by Krugman (1995). Although there are various types of increasing returns (external and internal) and various types of imperfect competition (monopolistic, oligopolistic and duopolistic), some common findings emerge. There exist multiple equilibria, patterns of trade are often indeterminate, and a country may not always gain from international trade. With such well-established findings, what is the contribution made by Gomory and Baumol? Jagdish Bhagwati comments, ‘They have cast new light on an old finding’. With a focus on external economies of scale, Gomory and Baumol explain how the distribution of production specialisations among countries affects the welfare of each country. They divide their book into two parts. Part I, which covers chapters 1–5, presents most of the results in a way that general readers (non-economists) can understand. Part II, which covers chapters 6–9, lays out the economic model used to derive the results. Chapter 10 is a literature review and Chapter 11 presents a preliminary empirical test. Chapter 1 includes a brief overview of the results. The authors emphasise that the modern world is different from the world two centuries ago when David Ricardo developed his theory of comparative advantage based on an agricultural economy. Today, many industries are characterised by large-scale operations and high entry costs. It is true that this recognition of change has been noted in many studies, however, this book pushes this to the limit to address the importance of the new trade theory. The authors define, in Chapter 2, a retainable industry as any industry that is characterised by high start-up costs where it is difficult to enter on a small scale. Then the rest of the book focuses on analysing allocations of these industries across countries and on considering the implications of these allocations on welfare. We know that these allocations have multiple equilibria, which has given us an impression that analysing the entire set of potential equilibria is implausible. However,

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Gomory and Baumol adopt an innovative approach so that they can classify all these equilibria into two groups (in the case of the usual twocountry world). As detailed in Chapter 3, when a country’s income share is either very low (say below 30 per cent as in Figure 3.5, p. 37) or very high (say above 70 per cent), there are always mutual gains to both trading countries if the low-income country acquires more retainable industries by switching from one equilibrium to another. When the countries’ income shares are not too different, moving from one trading equilibrium to another always generates conflicting interests (i.e., one country benefits at the expense of the other). These analyses and results are the book’s most important contribution to the new trade theory. While the authors hesitate to advocate any interventionist trade policies or protections, the policy implications of the above findings are very clear. Some examples, such as how a government can help a country move to a better equilibrium, are provided in Chapter 5. It is notable that the authors discuss sector-specific policies as well as general policies, such as R & D, with an emphasis on the latter. The same analysis can be also applied to the case in which entry costs are not high, but when there are productivity changes in one country, as in Chapter 4. The results remain unchanged qualitatively. Regarding the issue of how productivity growth in one country affects its trading partner, the literature concentrates on whether the growth occurs in the import or export sectors, but this book gives a new insight by providing answers based on the income gap between the two countries. Moreover, Gomory and Baumol provide a general equilibrium approach in which one sector’s productivity growth affects the other sectors via changes in wages and income. Finally, Chapter 11, a contribution by Edward N. Wolff, investigates whether or not there has been movement toward convergence in production patterns among industrialised OECD countries between 1970 and 1993. This is neither a rigorous nor a direct test of the theory developed in this book, but it is useful in the sense that it provides some systematic empirical findings that are consistent with the theoretical predictions of the book. There are several points at which readers should exercise caution. First, the analysis related to multinational corporations is weak. In contradiction with the authors’ prediction, we find that in the real world most activities of multinational companies occur in developed countries. As a result,

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equilibra fall in the zone of conflict. This is because multinationals are concerned with profits, but not the country’s welfare. Second, the book illustrates the welfare implications of all potential equilibria, but it would also be nice to see a more explicit analysis of how the degree of economies of scale and the size of entry costs affect the likelihood of each type of equilibrium (i.e., in the zone of conflict and in the zone of mutual gain). Third, the authors are able to use their analytical approach to examine many extended cases (see Chapter 9) such as looking at three or more countries. But it is easily seen that when the model goes beyond the twocountry setup, it becomes very difficult to identify the zone of conflict and that of mutual gain, giving little help to policy designers. REFERENCES Helpman, E. (1984), ‘Increasing Returns, Imperfect Markets, and Trade Theory’, in R.W. Jones and P.B. Kenen, (eds), Handbook of International Economics, Vol.1, North Holland, Amsterdam, 325–65. Krugman, P.R. (1995), ‘Increasing Returns, Imperfect Competition and the Positive Theory of International Trade’, in G.M. Grossman and K. Rogoff, (eds), Handbook of International Economics, Vol. 3, North Holland, Amsterdam, 1243–77.

LARRY D. QIU Hong Kong University of Science and Technology

Medical Care Output and Productivity, edited by D. Cutler and E. Berndt (National Bureau of Economic Research, USA, 2001), pp. xi + 611. The measurement of the output of the medical sector has long been a problem both theoretically and practically for both those involved in evaluation of the health care industry, and those involved in national accounts. Interpreting information about the relative shares of national income spent on health care in different countries is tempered by a lack of knowledge of the output, and consequently the productivity of this expenditure. Internationally many groups are involved in trying to improve the methodology of both expenditure and output measurement, in the United States one of these groups is the National Bureau of Economic Research (NBER). This book contains revisions of papers presented at the conference sponsored, among others, by

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NBER of ‘Medical Care Output and Productivity’ held in the United States in 1998. The volume consists of 15 papers, with most offering a commentary by another expert. The editors and authors are to be congratulated for the technical rigor of the papers and the editing, which is first class. The majority of the commentaries are well written and accurately discuss the positioning of the papers in the current literature. The volume is organised around four themes: conceptual issues; the current state of measurement; recent developments; and extensions of the frontier. As might be expected the contents of these chapters are very diverse, ranging from introductory chapters on the differences between health and other components of national health accounts to advanced discussions of specialist areas of compliance of pharmaceuticals. This limits the use of this volume for there will be few readers interested in the majority of papers presented, although most readers will find at least one chapter to be of interest. The collection of four papers making up the conceptual issues section offer a technical introduction to the issues around measuring inputs and outputs of the medical care sector. Issues of national accounting, cost effectiveness, non-profit hospitals and the indexing of prices are discussed. Most of the papers are interesting but essentially summarise the current approaches to these areas in health. The focus on the United States does limit the usefulness to the Australian reader. The second section of the current state of measurement identifies the current measurement techniques used in the United States. Although the first chapter of the medical care of the CPI in the United States is easily accessible, the remainder require some detailed knowledge of the health care system of the United States. The third section is on recent developments and is essentially a collection of empirical works on calculating the price or value of heart attack treatment, cataract surgery, arthritis and depression. Although these chapters use heterogenous diseases and techniques, they have a similar theme in that, with the exception of arthritis, the unit cost of treatment is not increasing and the quality is improving. The chapter on arthritis is an attempt to analysis the differences in drug prices in a hedonic framework. Given that in the medical setting consumption and prices are not set competitively, it is possible that the lack of measured quality improvement is a function of the technique used. The fourth section is on the future and focuses more on issues that are less well explored than the

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other sections and fit less well with the overall theme of the book. The topics covered are the econometric modelling of the value of reduction of child injury mortality, improvements in patients’ welfare with improved compliance and the allocation of publicly funded research. The last chapter on the allocation of publicly funded biomedical research in the United States was particularly interesting, but perhaps is not linked to the topic of the volume. Because of the authors and the conference from which these papers are drawn there is a focus of the United States and its rather unique problems, especially the high portion of the GDP that is spent on medical care, and the institutional structure that exist. This limits the generalisability of much that is discussed for an Australian audience despite the high quality of the majority of the work. Some sections will be interesting for the specialist reader and stimulate thought for research in their own area. The first section may be of interest to generalist economists wishing to extend their knowledge of the health care sector. In summary the book is what it claims to be: well written conference proceedings. PHIL HAYWOOD Centre for Health Economics Research and Evaluation

The Economics of the British Stage, 1800–1914, by Tracy C. Davis (Cambridge University Press, Cambridge UK, 2000), pp. xviii + 506. The application of economic analysis to the study of the performing arts is a comparatively new phenomenon. It is the product of the realisation that the motivation of performing artists and their managers is not substantially different from those engaged in more mundane pursuits. The fact that the arts are often organised by non-profit concerns makes no difference to this proposition. The relatively new Journal of Cultural Economics bears witness to the attraction of this field of economics. A natural extension of this field is a study of the economic history of the art market, the theatre, concert hall and opera house that will offer a corrective to the idea that the artist is someone untouched by realities of everyday commerce. Dr Davis’s book is therefore most welcome, if only for description in the most profound and

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astonishing detail of the financial fortunes of the British state over the 19th century. The text occupies 366 pages, the notes 92 pages, the bibliography 35 pages including 100 references to the Public Record documents. This chapter and verse approach may be an immense help to the dedicated researchers, though some scholars may be surprised to read that up to 1832 theatres were closed on 30 January to commemorate the execution in 1649 of Charles II (p.65) – not Charles I: a very curious lapse in the author’s apparently masterly grasp of detail. The economist seeking a central thread through the scholastic maze should hang on to profit maximisation as the motivating force in the evolution of the theatre, which should appeal to both market economists and Marxists alike – Dr Davis is clearly much taken with Karl. The story begins with the break-up of the Covent Garden and Drury Lane monopoly of drama in the 1840s, and the greater freedom of entry allowed, subject to the award of a licence by the Lord Chamberlain’s office. As economic analysis would predict, there was an attempt to capture the authorities by those obtaining licences to prevent further freedom of entry, but this largely failed. Up to the introduction of limited liability legislation in the 1860s, theatrical entrepreneurship was a risky undertaking, usually a family business, and which was increasingly subject to regulatory changes in order to meet with acceptable standards of hygiene, prevention of fire and safety provisions. Later in the Victorian period, there are interesting examples during a regime of limited liability of new forms of business organisation, including public ownership by local governments of theatres which let out to theatre companies. Management became more sophisticated as technical change allowed them to choose between in-house assembly of inputs (such as scenery and costumes) and outside contracting. Larger potential audiences began to display a more critical appreciation of artistic standards, and performances achieved a unity unknown when my great-great uncle’s benefit performance at Barnsley in 1847 included Garrick’s version of ‘The Taming of the Shrew’, a comic sketch entitled ‘The Dumb Belle’, a drama called ‘The Memoirs of the D – L’ and even a Hornpipe performance by a Miss Andrews. Sixty years later they were much less content with a series of tableaux and the more discerning, even provincial, audiences expected to be able to attend performances of original serious plays by contemporary dramatists.

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In Dr Davis’s exposition, the devil is not in the detail, but in the curious framework which is supposed to justify the title of the work. There is a vivid contrast between the meticulous study of individual cases, notably in a splendid chapter on the wiles of women intent on participating in theatrical entrepreneurship, and the vague thesis that the economic theory of the time was in some way consonant with and may have influenced public policy and tastes. It may make sense to associate the loosening of government interference in the theatre with acceptance of laissez-faire doctrines, but the idea that marginal utility theory was some kind of precondition for the development of consumer taste and therefore had some bearing on the growing acceptance of nudity on the stage takes some swallowing. The author’s range of knowledge of economic literature suggests that her refusal to draw upon modern economic analysis of the performing arts is quite deliberate, and at least this calls for proper justification. However, if cultural economists are disappointed and irritated by this cavalier treatment, they are bound to see this as a serious and highly original contribution to business theory. ALAN PEACOCK The David Hume Institute

John Maynard Keynes. Fighting for Britain, by Robert Skidelsky (Macmillan, London, 2000), pp. xxiii + 580. John Maynard Keynes. Fighting for Britain is the third and concluding volume of Robert Skidelsky’s acclaimed biography of the twentieth century’s greatest economist. The complete work is a masterpiece, one of the truly great biographies of the past century. For the author, it represents the culmination of almost 30 years of sustained and disciplined research. The third volume, however, does not quite reach the heights achieved by the second volume, which covered the years of Keynes’s major contributions to economic theory. Certainly economists and historians of economic thought will find the second volume of greater interest to them than the third, though this may not be the case for economic historians. Be that as it may, there are signs that the author has rushed the completion of the work: there is a considerable amount of tedious detail, the minutiae of international negotiations,

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which might have benefited from more thorough pruning. Nor is there the same degree of focus on Keynes’s personal life as there was in the earlier two volumes, which helped to sustain the reader’s interest. This, perhaps, is understandable, for Keynes was chronically ill for much of the time covered by this volume, and he chose to conserve his energy for the formulation of policy and the shuttle diplomacy that he conducted between the United Kingdom and the United States. Put simply, there was precious little time for him to pursue activities beyond those of immediate urgency, though he managed to find time for those people and activities that really mattered to him: his wife, parents and close friends, his school and college, and the arts. These criticisms, however, are merely peccadilloes, for the final volume of the Keynes trilogy remains a magnificent work, and its reading is recommended to all economists with an interest in the history of economic thought and policy in the twentieth century. The book opens with Keynes’s recovery from the ‘heart attack’ he suffered in 1937. From then, until the outbreak of war in 1939, his major interest centred on problems of macroeconomic policy in Britain as economic recovery proceeded within the context of increasing public expenditure on rearmament. How to stabilise the economy in conditions of rising aggregate demand was the subject of several newspaper articles Keynes wrote for The Times between 1937 and 1939. As unemployment continued to fall, he began to shift his attention to problems of excess demand and inflation, calling as he did for measures that would serve at once to prolong the boom while dampening inflationary impulses. At first he argued that increasing levels of aggregate demand should be redirected to those regions where unemployment remained excessive. Later, in the booklet, How to Pay for the War (1940), he recommended that private demand should be curtailed through the imposition of a compulsory levy on personal income, the proceeds of which would be held in the form of compulsory savings that could be released later when the postwar boom began to evaporate. Regrettably, How to Pay for the War has been somewhat neglected in the history of economic thought. This is unfortunate, since a reading of it would seriously challenge the view that Keynes was insensitive to inflation. For How to Pay for the War constitutes an analysis of the ‘inflationary gap’, a phrase coined by Keynes himself, and the policies required to avoid or eliminate it.

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In his discussion of Keynes’s writing on economic policy after the publication of the General Theory, Skidelsky introduces one of the central themes of the book, namely, Keynes’s dedication to the market economy and his rejection of what Skidelsky calls ‘Schachtian economics’, and what Keynes himself called ‘Bolshevism’, the adherence by the political Right and Left to systems of direct controls and other antimarket processes. Skidelsky argues that it is a misconception of Keynes’s economics to regard it as antimarket, or indeed that Keynes was soft on inflation, refuting the claim that Keynes’s purpose was to create and maintain excess demand and over-full employment through budget deficits and the imposition of authoritarian controls upon prices, incomes, production, distribution and trade. Instead, Keynes led a crusade throughout the years covered in this book to combat this approach, winning as he did the support of Hayek, Robbins, Meade and Robertson, against Henderson, Balogh, Beaverbrook and others. Not only is How to Pay for the War a manifestation of Keynes’s commitment to the conceptual framework of the General Theory, but is also a demonstration of the usefulness of that framework for dealing with an economy experiencing an excess of aggregate demand. The other major theme of the book concerns the international financial negotiations undertaken by Keynes during the war and its immediate aftermath, especially his six missions to the United States, beginning in 1941 with negotiations over Lend-Lease before the entry of the United States into the war, continuing with the Clearing Union/Stabilisation Fund and the Bretton Woods Conference, and culminating in the American Loan to the United Kingdom. Here, Keynes is portrayed as ‘Fighting for Britain’, the patriot who was perpetually seeking the best terms for his country. It was in this context that Keynes conceived the idea of an international economic and financial mechanism that would help Britain meet its massive international liabilities accumulated during the war without having to sacrifice domestic demand. In great detail, Skidelsky takes the reader through Keynes’s negotiations with the United States, specifically with his counterpart in the United States’ Treasury, Harry Dexter White. Of incidental interest here is the attention Skidelsky gives to the probability that White was a Soviet agent, whose motive was to thwart Keynes’s objective to strengthen Britain’s postwar

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economy. In contrast to Keynes, White’s aim was to ensure that Britain entered the postwar world significantly weakened, opening up the possibility of a postwar alliance between the United States and the Soviet Union. In the event, White’s Stabilisation Fund won the day over Keynes’s Clearing Union because, as Keynes put it, while Britain had the brains, the United States had the money. Similarly with the negotiations over the American loan; Keynes did not secure the grant, or the amount, he thought Britain deserved in compensation for its disproportionate contribution to the war, because the United States held the superior bargaining position, based on its overwhelming economic and financial strength. In all these negotiations it is true that Keynes failed to obtain in full measure what he set out to achieve. But Skidelsky is perhaps inclined to diminish Keynes’s achievement. After all, an international monetary institution, designed to provide economic stability and harmonise internal and external balance, was established. The International Monetary Fund (IMF), to be sure, was based on a fund, rather than upon the banking principle of credit creation, as Keynes had proposed; it was designed to put pressure on debtors to correct their imbalances, rather than upon both debtors and creditors; the exchange rate was to be decidedly more rigid than Keynes had wanted; and it was to be much more political with respect to its governance and location, rather than a technical organisation located away from a seat of government, as Keynes had sought. Yet it may be doubted that, but for the persuasive powers of Keynes, the IMF and World Bank would ever have seen the light of day. The same could be said about the negotiations over the American Loan. It is true that, as Skidelsky argues, Keynes may not have been in the first rank as an international negotiator, but he provided the intellectual firepower for the American Loan in his famous memorandum of 18 March 1945, entitled ‘Overseas Financial Arrangements in Stage III’. If there was any failure attaching to Keynes with respect to the American Loan, it was with the timing. He was perhaps over-anxious to draw upon the wartime collaboration between the United States and the United Kingdom before the goodwill of that time evaporated, as he thought it might as the war years receded. He did not foresee that the threat from the Soviet Union would alter American opinion so dramatically regarding the funding of recovery in Western Europe and the provision of aid in the form of generous grants

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associated with the Marshall Plan. Had the negotiations for the loan been delayed for a year or two it is possible that the terms upon which the United States might have been prepared to extent credit to Britain would have been somewhat easier than they were in 1945. Perhaps there is something to be said for Skidelsky’s claim that Keynes’s declining health contributed to the urgency of finalising the loan negotiations. Of the two central themes of the book, Skidelsky is inclined to stress the second rather than the first. But for economists, it is possibly the first that is of greater importance. If it does nothing else, this volume will allow Keynes to be seen in his true light as one whose abiding aim was to preserve the market system because of its greater efficiency and freedom to choose compared with alternative economic systems. It is true that Keynes had long adopted the view that the market system could not be relied upon unaided to solve all the economic problems facing mankind. Given that, his task was to fashion solutions that would overcome its deficiencies while maintaining its fundamental elements. He may have been fighting for Britain in his negotiations with the United States, but he was also fighting for the preservation of Britain’s traditional economic and political institutions. Domestically, as Skidelsky shows, Keynes had to battle continually against those – the Schachtians (of the Right) and the Socialists (of the Left) – whose object was to impose upon Britain an authoritarian regime of direct controls, physical planning of resources, rationing and nationalised industry, a totalitarian state altogether antithetical to the program which Keynes himself had adumbrated in his General Theory, and indeed in all his writings on economics before and since the publication of that great work. After almost 30 years and nearly a million words, what does Keynes’s biographer identify as the kernel of his subject’s greatness? It is a pity that Skidelsky does not attempt a consolidated appraisal of Keynes’s contribution to economic thought and policy. Rather, one has to piece together from comments scattered throughout the third volume, including the Introduction and the Epilogue. Here is one quote that comes as close perhaps as one can get to Skidelsky’s conception of Keynes’s essence: ‘He was not just a brilliant person… What makes Keynes stand out from the throng of the highly gifted is what Lytton Strachey might have called ‘‘the fearlessness of his cerebration’’. He was incapable of banality; on any subject he turned his mind to, even momen-

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tarily, he would come up with a thought unexpected, arresting, original’ (pp. xxiii). Our discipline can be justly proud that this great man chose economics as his profession. SELWYN CORNISH Australian National University

The Economics of the Apprenticeship System, by Wendy Smits and Thorsten Stromback (Edward Elgar, Cheltenham, UK, 2001), pp. x + 168. The Economics of the Apprenticeship System is an informative, thoughtful, well-researched and up-to-date compilation of the existing theoretical and empirical literature on apprenticeship. The book is enriched by a temporal perspective. The authors do not focus solely on the current state of apprenticeship but present the institution as a dynamic entity, whose history spans more than 2000 years. Smits and Stromback also offer a broad geographical perspective – describing apprenticeship across Europe and the British colonies of North America, Australia and New Zealand. Alas they do not include Asia or Africa. The geographical and temporal dimensions make for a wideranging and in-depth treatment of the subject. Smits and Stromback begin by tracing the history of apprenticeship from some of the earliest surviving records (Greece, AD 36). From there we travel through early medieval Genoa, Paris, Bologna and London. We next read about the form of apprenticeship between roughly the 15th and 18th centuries in England, France, Sweden and Germany, when craft guilds were particularly influential. While exposing the reader to some of the variation in the terms of apprenticeship, such as in contract duration and fees, the authors stress the similarities in apprenticeship. For example, regardless of location or historic time period, contracts tended to include a rather vague statement to the effect that the master was obliged to teach the apprentice the whole of his trade, without any indication of the specific tasks to be taught or any time frame for the education. The industrial revolution and the dismantling of the guild system reduced the number of apprentices but did not obliterate the institution. Small, but still functional in the 20th century, the form of agreements was amazingly similar to their counterparts centuries before.

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Apprenticeship in the British colonies, while similar, was unencumbered with the guild system. Most of the American literature links the absence of guilds to the relative instability of the colonial institution, which apparently was plagued by ‘runaways’ that left their masters before the end of their term. Interestingly, instability does not appear to have been a feature of the Australian or New Zealand experience, despite a similar absence of guilds. Apprenticeship agreements appear at odds with the standard Gary Becker theory of training because boys typically do not pay for their training, despite the fact that most of the skills they acquire are transferable. Chapter two develops a range of possible theoretic solutions to this conundrum. The models offer various explanations for why employers might have an incentive to invest in general training. The first set of models also address one of the puzzling features of these contracts – their long and fixed duration (i.e., contracts always specified how long the apprenticeship would last). If the parties can agree to a contract length that exceeds the duration necessary for training, the firm will have incentive to invest in general training in the case of either imperfect capital markets (where apprentices cannot finance training) or ‘non-verifiable training’ (training not easily verified by a third party, such as a court of law). This follows because during the ‘extra’ time the apprentice’s productivity will exceed his wage, hence the firm will reap some of the return from training. A number of other possible scenarios can yield a gap between an apprentice’s wage and productivity (and so provide the firm some incentive to invest in general training). In a very useful review of a varied and complex literature the authors offer six such models. A number of them involve asymmetric information, where the training firm is more knowledgeable about (for example) the training or ability of the worker. Other models consider the effects of unions, uncertainty and minimum wages (or wage guarantees). In a number of these cases the training outcome may be less than socially optimal – a result the authors’ state accords with policy makers’ view of apprentice training. Smits and Stromback also consider the impact of a firm-specific element to apprentice training. Their versions of these models are straightforward and the notation standardised, making it relatively painless to follow from one model to the next.

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Drawing on the array of models developed in the previous chapter, Chapter 3 focuses on the most likely theoretic candidates that can explain some of the more enduring features of the historic apprenticeship (such as the incomplete specification of the training obligation). It also addresses the principal changes in apprentice contracts (like the growing importance of regulation). The chapter is very interesting and also the most contentious. The authors argue that credit constraints were a particularly relevant feature of the traditional apprenticeship, and explain the fact that parties specified a fixed apprenticeship duration in the contract. To support this argument, they state that ‘a boy’s family could rarely even provide food and shelter for all their children beyond a certain age’ (p. 72). This is a strong statement. It seems likely that at least some parents could support their families and were not credit constrained, and yet prior to the 19th century children rarely pursued an apprenticeship while living at their own home, and thus (presumably) enjoying a shorter term. Perhaps other factors help to explain the prespecified (or fixed) contract length. In North America, not living with the master became more common in the 19th century. What changed? Were people wealthier, did access to credit change, or do other factors explain this phenomenon? Smits and Stromback do not address this issue, but they do argue that the credit constraint became less binding. They point to the rising incidence of ‘premiums’ in Europe (up front payments to masters), and the replacement of in-kind with cash payments that tended to rise over the course of the apprentice’s contract. They do not, however, identify the root cause of these changes. Similar questions arise in the discussion of the changes in contract duration. Smits and Stromback claim that the shorter length (now 2–4 years instead of the 5–7 years common centuries before) is a result of ‘longer schooling and changing norms about what constitutes reasonable contractual restrictions’, both factors that are ‘exogenous to the apprenticeship system.’ (p. 92). At least in North America, however, the decline in apprenticeship length began well before any changes in the provision of public schooling (Hamilton 2000). It is not at all clear that the changes in duration, pay and living arrangements were exogenous; more work needs to be done before we fully understand these phenomena. The remainder of the book covers a wide array empirical evidence on current apprenticeship that

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sheds light on some of the theoretic issues developed in previous chapters. One of the main topics is the net cost of apprenticeship to employers – a cost found to be substantial across a number of countries. They report on studies that make use of the usual sorts of data on training costs, but also include an Australian study that uses survey data (they asked employers about the cost of hiring apprentices). Comparing the results of the two types of studies is quite interesting, as they are dramatically different. All of the results present a bit of a puzzle, because the large net cost makes it difficult to understand why employers hire apprentices. The authors discuss possible biases in these studies, and consider possible post-training returns that were not adequately captured in the costbenefit studies. These studies examine (for example) retention rates and subsequent mobility of apprentices, as well as the earnings of apprentices who leave directly (or soon) after training with those that stay with the training firm for an extended period of time. Reflecting the lion’s share of recent empirical literature, most of the focus here is on Germany. Smits and Stromback then switch to the supply side of the market. They include studies on the returns to an apprenticeship and occupational mobility. Throughout the empirical section, the authors note that there is considerable variation in training methods by firm size, industry, and country. This helps to explain the variety of results. It also helps explain why they do not describe the exact nature of an apprenticeship in any detail (what tasks the apprentice does at various stages of the apprenticeship, the time frame and exact nature of his education, etc). On the other hand, such a description for one or two representative firms would have been enlightening. Nonetheless, this is a very useful book for anyone interested in training or apprenticeship, from either an academic or policy perspective. It summarises a wide range of both theoretic and empirical literature, pointing out (either directly or indirectly) gaps in the current literature, which should stimulate future research. REFERENCES Hamilton, G. (2000), ‘The Decline of Apprenticeship in North America: Evidence from Montreal’, Journal of Economic History 60, 3.

GILLIAN HAMILTON University of Toronto

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Practical Applications of Approximate Equations in Finance and Economics, by Manuel Tarrazo (Quorum Book, Westport CT, USA, 2001), pp. xii + 183. This is a book with a message – that we should change the way we model equation systems in finance and economics. The author points out that conventionally we have used simultaneous equation systems (SES) that produce precise numerical solutions which in a sense never occur. As point estimates they generally have a probability measure of zero. Approximate equation systems (AES), however, are SES with an error attached to the coefficients. ‘The variation that coefficients may assume before the equations system breaks down can be an indicator of information strength in the model. This error adds flexibility to the original SES while preserving the delicate and comprehensive informational structure.’ (Tarrazo p. x). The author proceeds to make his case for the use of AES in a number of areas of social science applications. Like Gaul, the book can be divided into three parts: • Part 1 – simultaneous and approximate equations (Chapters 1, 2). The author outlines the method of simultaneous equations systems and offers a preliminary assessment of its usefulness in economics and finance. He then delivers a statement of the logic of approximate equations systems and a sketch of the principles of its solution. • Part 2 – applications in macroeconomics, financial planning and portfolio selection (Chapters 3–5). The author focuses on the AES method in use in macroeconomics, financial planning, and portfolio selection. • Part 3 – extensions (Chapter 6). In the concluding chapter of the book, the author considers some technical extensions such as dealing with non-linear and dynamic equation systems, and some philosophical issues such the linkages between qualitative and ‘words-based’ methodologies in economics and finance and more traditional quantitative methods. The fundamental idea of AES is that we should not take the coefficients of quantitative models to be precise point estimates but should see them as values on some interval. Consider the following simultaneous model:

½1  ex1 þ ½2  ex2 ¼ ½4  e ½1  ex1 þ ½2  ex2 ¼ ½8  e Note that each coefficient has an ‘error’ of e. If the error is set to zero, we obtain a single point solution (2, 3) of this equation system in twodimensional space. If the error is e ¼ 0.1, then the domain of x1 is [1.454, 2.667] and the domain of x2 is [2.714, 3.316]. If the error term is e ¼ 0.7, the domain of x1 becomes [)2.666, 16] and the domain of x2 is now [1.444, 6.230]. With a nonzero error we produce a solution surface in two dimensions. The surface need not be convex, as Tarrazo shows on page 29. The larger the error, the greater the area produced. With more variables, the dimension of the solution space increases. The simple example illustrates several issues and maintained hypotheses of the AES approach. The error is assumed to be the same on all parameters. The error also applies to the ‘intercepts’ in the equations as well as the ‘slope coefficients’. A less obvious point is that if the system of equations is not critically ill-conditioned then it will provide solutions in one set including the SES (zero error) solution; but if the system becomes ill-conditioned the solution sets may be disjoint. What do we gain from this move to reduced precision in our solutions? First, Tarrazo emphasises that the errors are not simply measurement or other probabilistically based errors, but are a reflection of overall model reliability. Informational strength and numerical uncertainty are the target of the error structures assumed in AES. Model robustness is better reflected with AES than with SES. The latter imparts a spurious accuracy to a model. Second, there are some specific interesting insights. In Chapter 5.3, Tarrazo points out that the empirical evidence in finance indicates that we often have better estimates of standard deviations of returns than we do for mean returns. The AES method allows us to use smaller error ranges on the standard deviation values than on the means, and so provide a better sense of informational robustness than we currently do with SES models using point estimates for all the moments. Tarrazo did not invent AES – an early author writing comprehensively in the field was I. Kuperman in his Approximate Linear Algebraic Equations (Kuperman 1971) – but has worked hard to establish applications in economics and

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finance. The techniques he uses are part of ‘Interval Mathematics’, that include fuzzy set theory and interval matrices. Tarrazo points out, however, that the existing literature, especially in economics and finance, is not a heavy user of the interval methods. No doubt in part to make up for a dearth of writing in these fields with the applications of AES, the author has written an astonishing number of papers since 1997 on the topic in addition to the book being reviewed here. As with all lengthy writings, there are small points of errors or omissions. On pages 90–91, the variable ‘Sold’ is undefined, and there appears to be an inconsistency in the terminology of ‘SNew’ and ‘Sold’; and page 95 then uses ‘S’ for sales as yet another nomenclature. On pages 115–117 the author seems to conflate the Capital Market Line with the Security Market Line of CAPM. A further area of analysis not mentioned by Tarrazo is the ‘specification search’ methods of Edward Leamer, although this is driven by a statistical basis rather than the all-encompassing imperfect information approach of the author. Tarrazo’s case is a very appealing one. He is seeking a method that is applicable – justifying the use of some simplifying assumptions as noted above – but that satisfies methodological imperatives from normal science. The AES encompasses the SES, but allows the user to evaluate robustness and incorporate actual ignorance about estimated coefficients. The book, or at least extracts from it, should find a place in reading packs of all courses on applied methodology in the social sciences and more advanced courses in finance and economics. REFERENCE Kuperman, I.B. (1971), Approximate Linear Algebraic Equations, Van Nostrand Reinhold, London.

CHRISTOPHER M. ADAM Australian Graduate School of Management

Future Directions for Monetary Policies in East Asia, D. Gruen and J. Simon (eds) (Reserve Bank of Australia, Sydney, 2001), pp. 205. This book contains contributed papers and discussions from the latest in a long line of excellent conferences hosted by the Reserve Bank on topical issues. The focus of this conference –

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held on July 24, 2001 – was to examine the role of monetary and exchange rate policies in the East Asian region. The ultimate aim, it seems, is to select an optimal policy for countries in the region from a menu of monetary and exchange rate arrangements that appear in the literature. The menu, as noted in David Gruen’s introductory remarks, contains a diverse range of regimes making the search for optimal policies a nontrivial one. The first contribution, Robert McCauley’s ‘Setting Monetary Policy in East Asia: Goals, Developments and Institutions’ concludes that, since the crisis, several economies in the region have taken steps to provide institutional support for monetary policy and the objective of price stability. There remains a general reluctance to allow exchange rates to float – although it is noted that the volatility of exchange rates relative to interest rates is higher now than pre-crisis. This is attributed to the openness of several economies in the region and concerns about the effect of exchange rate movements. These economies have a greater incentive to regulate currency movements and McCauley makes the interesting (and good) point that the more open an economy, the more they are able to acquire foreign currency reserves and hence intervene to support their currencies. Guy Debelle’s ‘The Case for Inflation Targeting in East Asian Countries’ makes a strong case in favour of an arrangement comprising flexible exchange rates, an inflation target and a monetary policy rule (in the language of Taylor 2000) to be employed to pursue the target. He acknowledges that there are difficulties with implementing this strategy in emerging market economies notably the choice of instrument and the ability to forecast inflation. A noteworthy prerequisite is for central banks in the region to have goal dependence combined with instrument independence. The idea is to enhance credibility by ensuring that the central bank and the political process have the same objectives but that the instrument/s of monetary policy is free from political interference. John Williamson’s ‘The Case for a Basket, Band and Crawl Regime for East Asia’ proposes a system similar to Singapore’s, with some alterations. The basic idea is for economies in the region to peg to a basket of currencies that is more reflective of their diversity of trade than pegging to a single currency. The weights of each currency in the basket would be public knowledge (in contrast to the Singapore case). The currency

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would be permitted to move within a band, therefore allowing some flexibility in monetary policy or to better cope with capital inflows. The final component of the system is to allow the currency to crawl so as to manage inflation over the medium term. The fourth paper, by Charles Wyplosz, entitled ‘A Monetary Union in Asia? Some European Lessons’ looks primarily at how Europe achieved its monetary union and assess whether or not East Asia may possess any of the same prerequisites. Wyplosz finds more differences than similarities. The main differences can be broadly split into two. The first is the incompatibility of the sequence of events that potentially lead up to a union. In Asia, liberalisation of the capital account has occurred before exchange rate stability. This was the reverse in Europe. Also, in Asia, the focus seems to be on monetary cooperation before trade cooperation – even though there is some progress being made on trade agreements. The second is the preparedness of East Asia to establish institutions for a collective approach to monetary policy. As Wyplosz mentions in section 2, ‘If the adoption of a peg is to be part of a regional agreement, it must be backed by adequate institutions’. Andrew Coleman’s ‘Three Perspectives on an Australasian Monetary Union’ provides an interesting counterpoint to the usual analysis of monetary integration by asking what would happen if Queensland adopted a separate currency. He also provides insights into the possibility of New Zealand and Australia adopting a monetary union. A variety of issues and themes are covered in the volume. The main theme was the effect the openness of most of the economies in the region. This was expressed in various degrees by authors and discussants alike. The issue of openness provides quite useful information as to why there is some uncertainty and inconsistency in the way the region has approached monetary policy (see de Brouwer’s discussion of McCauley’s paper). An open economy’s trade would be harmed by volatile exchange rates thus providing an incentive to fix. But it is the openness of an economy that leaves it vulnerable to a speculative attack – thereby providing an incentive to float. As a result, we find several countries adopting intermediate exchange rate arrangements and the empirical findings of McCauley support this. Debelle and Williamson also provide arguments that generally support

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intermediate arrangements. This represents a departure from the bipolar view (see Fischer 2001) of exchange rate regimes that has been gathering momentum in the literature in recent times. The ‘BBC’ system offered by Williamson is very well thought out. Indeed, if some degree of exchange rate rigidity is desired, a basket peg has enormous merit. This is especially pertinent in East Asia where its trade patterns suggest a peg to the $US may not be optimal. (See Table 6 in the paper by Wyplosz for information on the extent of East Asian trade with the USA). A recurring point throughout the conference is that an intermediate regime may be necessary as part of a transition to a monetary union. The drawbacks to intermediate schemes are well documented. One problem concerns the conflict of objectives between stabilising the exchange rate and pursuing an inflation target. Alejandro Werner in discussing Debelle’s paper presents evidence of conflicting goals from the Chilean experience in 1998. Since much has been written about the power of monetary policy, it seems a shame not to be able to fully exploit it rather than have it compromised by (often) conflicting objectives. Another problem with intermediate schemes revolves around credibility. It is true that this has not received as much attention in the recent literature. Indeed, Chang and Velasco (2000) maintain that credibility ‘seems to be less compelling than it once was …’ (for a discussion on credibility in emerging market economies, see Eichengreen (2001) and Obstfeld & Rogoff (1995)). There seems, however, to be a certain X-factor characteristic to credibility. It’s very difficult to work out what’s needed to attain it. Most papers in this volume write about transparency and accountability as important conditions to credibility. They are indeed, but it seems they’re neither necessary nor sufficient. Take transparency. Singapore and Hong Kong both have credible regimes, but only Hong Kong’s can be called transparent. What’s the missing ingredient? Perhaps the one that has come closest to establishing credibility is central bank independence. In sum, this conference volume provided competent coverage of the predominant exchange rate systems that are available to policymakers in conjunction with the issues that might possibly facilitate or constrain them from implementing their policies.

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REFERENCES Chang, R. and Velasco, A. (2000), ‘Exchange Rate Policy for Developing Countries’, AER Papers and Proceedings, 90(2), 71–75. Eichengreen, B. (2001), ‘Can Emerging Markets Float? Should They Inflation Target?’ elsa.berkeley.edu/users/eichengr/policy.htm Fischer, S. (2001), ‘Exchange Rate Regimes: Is the Bipolar View Correct?’, Journal of Economic Perspectives 15, 3–24. Obstfeld, M. and Rogoff K. (1995), ‘The Mirage of Fixed Exchange Rates’, Journal of Economic Perspectives 9, 65–70. Taylor, J.B. (2000), ‘Using Monetary Policy Rules in Emerging Market Economies’ http://www.stanford.edu/~johntayl/

TONY CAVOLI Adelaide University

Monetary Policy Rules, edited by John B. Taylor (University of Chicago Press, Chicago, 2001), pp. 447. This book brings together nine papers written by 17 authors who were gathered together at a conference organised by the book’s editor (and contributing author), John Taylor. Each chapter focuses on a single paper, a discussant’s prepared response, and a summary of the verbal discussion that took place. This book will be of great interest to economists and central bankers – particularly those living in Australia, Canada, the Czech Republic, New Zealand, Sweden, and the United Kingdom where the central banks explicitly practice inflation targeting. The book’s goals are: (i) to use econometric evidence to discover which of a variety of monetary policy rules are likely to be efficient and robust when used as a guideline for the conduct of U.S. Monetary Policy; and (ii) to settle several issues critical to the conduct of monetary policy with rules (e.g., the role of uncertainty about potential GDP, utilisation of exchange rates when setting the rule’s interest rate target, etc.) All of the authors address the book’s goals by using versions of the Taylor Rule which can be written generally as: iT ¼ GP PT þ GY YT þ qiT 1

ð1Þ

where i is the nominal interest rate, P is the inflation rate, Y is real GDP measured as a

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deviation from potential GDP (and where the intercept is ignored). Each author was asked to evaluate, in their own economic models, the performance of a common set of five variations of equation 1. Consequently, rule performance was evaluated in; (i) macroeconomic models that ranged in size from three equations to 98 equations; (ii) models differed in their degree of openness to foreign economic variables; (iii) models with different degrees of forward-lookingness (i.e., rational expectations); (iv) models that differed in the explicit use of microfoundations in their construction; and (v) models that used different means to estimate parameters, etc. Despite these differences, the evaluations also shared some similarities. Each model used is a dynamic, stochastic, general equilibrium model. Each model incorporates some form of a temporary nominal rigidity which leads to short-run tradeoffs between inflation and real GDP (or unemployment). In the long-run money is neutral. The measure of each rule’s economic performance depends on the variability of inflation around a target rate, and the variability of real output around a measure of potential or full employment output. In some cases rule performance is judged by also examining the variability of unanticipated inflation and the variability of interest rates. An important result of the extensive robustness testing is that there are many common findings across papers. For example: (i) simple rules perform almost as well as complex rules in any given model and actually outperform complex rules when judged across a variety of macroeconomic models; (ii) rules that use historical values for the right hand side parameters (i.e., backwardlooking rules) perform almost as well as those that use forecasts of future values of the right hand side parameters (i.e., forward-looking rules) in setting current quarter interest rates; (iii) using one quarter lagged values of inflation and the output gap in equation 1 produces little deterioration in rule performance; and (iv) in the openeconomy models rule performance was improved by adding exchange rates as a parameter to the right hand side of a Taylor Rule and to the policy instrument (more attention should be given to this result’s implication that all future modelling should be done with open economy models and that traditional Taylor Rules should be modified to explicitly incorporate exchange rates). Another outstanding feature of the book is the contributions of the discussant’s papers and the summary

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of the discussions that occurred at the conference. The discussion papers by Donald Kohn and Fredric Mishkin will be particularly valuable to researchers hoping to persuade central bankers to utilise rules directly or as guides in the formulation of monetary policy. Kohn currently is the Secretary of the U.S. Federal Reserve Board’s Federal Open Market Committee and Mishkin was the Director of Research at the New York Federal Reserve Bank. Their insights into the thinking of central bankers are invaluable. The book does have some flaws. Many researchers, including McCallum (1988, 1990) argue that to be successful rules must be: 1 robust to changes in technology, financial innovation, and regulation; 2 transparent enough to allow the public to monitor central bank compliance with the rule; and 3 fully operational. Most of the ‘rules’ in this book do not possess these characteristics, and so they are really central bank reaction functions – not monetary policy rules. This is an important distinction for several reasons. First, the channels through which interest rates (and exchange rates) affect inflation and the output gap do change over long periods of time in response to changes in technology, financial innovation and regulation. (Taylor notes this in Chapter 7). However, there is no mechanism in the various Taylor Rules to automatically change the coefficients on the right hand side parameters in response to these types of change. This is in stark contrast to rules such as those proposed by McCallum (1987, 1988, 1993), and in fact, McCallum is the only author in this book who examines rules whose performance is invariant to changes in technology, financial innovation, and regulation. Some problems with relying on central bankers to make coefficient changes as needed are that it makes monetary policy too reliant on the skills of the individual central bankers in office and provides an avenue for the time inconsistency problem to negatively influence policy decisions (Kydland & Prescott 1977). Further, ‘rules’ that use future or current values of right hand side variables are not transparent. The central bank may announce its forecasts of future right hand side variables, but the public is generally not sophisticated enough to monitor the

legitimacy of those forecasts, and if current quarter values of the right hand side parameters are used, the central bank must still forecast those variables, because data on inflation and real GDP are not available in real time. Third, as Orphanides (1998) notes revisions to the first estimates of GDP and inflation data lead to differences in the interest rate settings ranging up to 200 basis points in Taylor Rules calculated with data available at the time a monetary policy decision would have been made, versus decisions simulated with the data series that exist several years later. Evaluating versions of equation 1 with one-quarter lagged values of inflation and the output gap do not address the Orphanides critique because accurate values of the lagged variables are still not available to central bankers at the start of the subsequent quarter. Orphanides’ (1998) results are important, and in order to persuade central bankers of the case for monetary policy rules, researchers need to address it. Despite these shortcomings Monetary Policy Rules is an outstanding contribution to the literature and a must read for anyone interested in monetary policy. REFERENCES Kydland, F. and Prescott, E.C. (1977), ‘Rules Rather than Discretion: The Inconsistency of Optimal Plans’, Journal of Political Economy, 85, 473–91. McCallum, B. (1987), ‘The Case for Rules in the Conduct of Monetary Policy: A Concrete Example’, Federal Reserve Bank of Richmond Economic Review, 73, 10–18. McCallum, B. (1988), ‘Robustness Properties of a Rule for Monetary Policy’, in A. Meltzer and K. Brunner, (eds), Carnegie-Rochester Conference Series, North Holland, Amsterdam, 173–204. McCallum, B. (1990), ‘Targets, Indicators, and Instruments of Monetary Policy’ in W.S. Haraf and P. Cagan, (eds), Monetary Policy for a Changing Financial Environment, AEI Press, Washington D.C. McCallum, B. (1993), ‘Specification and Analysis of a Monetary Policy Rule for Japan’, Bank of Japan Monetary and Economic Studies, 11, 1–45. Orphanides, A. (1998), Monetary Policy Rules Based on Real Time Data, Finance and Economics Discussion Paper No. 98–3, Washington D.C. Board of Governors of the Federal Reserve System.

SARANNA R. THORNTON Hampden-Sydney College