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FEDERAL H~~~HV~ RESERVE ~~U~HAL  OF DALLAS BANK Of January 1991  •  •  conOIlllC conOIillC eVlew The Long-Run Effects of ofa a Permanent Change in Defense Purchases Mark A. Wynne  \  Europe 1992: An Overview Linda C. Hunter linda C.  This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (  Economic Review  _.. _.-..  Federal Reserve 8an~ of Dallas Aobert H. Boykin a-It:..Mw()ll_  HI'"r Rosenbillm s..v.c. ....... 1NI G.r. l~  P. O'Oriscoll, Jr, ~_Dowaotd~  ........... ,--  W. Michl,1 Co)!  Stephen P. A. Brown AWl!lI'IIl'DfW_MIII  s.tIII1tC_'  EconomilU Na!lOnai and Inter",wooal John K Hill Evan f Koenig  Robert T Clall Joseph H Haslag Kenneth M Emery  David M Gould Mar\( A. INynne KeYIn J VealS  RegIOflaI MId fnelgy William C Gruben  Rmen W Gilmer MUle I( Yucel'l II PhIllips tOl'll Taylor  Fona 0 Stgalla Editon Ahonda Hams Olana W Palmer Virginia M Rogers  The E~ Re_ IS po,obhshed by !hI! fede..1I\e$efve Ban~ of Dallils The VIews I'" ll'eueIi arl time 01 !he IUIlIClfJ ..., 60 1'101 necessarily refleer the poslt>CW'lS of lIIe F«*al Reserve Sanl: 01 Oilln 01 the F«Ieral Resetve S'f$11IIII  $ub$uopbOllllrlt ;m~able fr.. III ~r9t  Pliise se,", requests 'Of IIrg'l>topy and ~  todIi'ess  WbserI(lllIJ'lS.  bid _ _  c:IIanIJeS lO.tIt I'IA:IIoc  ~  Aftao Depart.  mtm. f«Ierfi Re_ 8.ri 01 DaIIS. Sal .... K. ~ 75122, (21.)651...Q89  Ar1Ides!"~ 01  reprl'l18O on tilt CO'Oto'I and !he Rese¥tll DfP¥Imem IS prOVIded W'th iI (W'/ 01 the llbIIcMoon (Of'liUIW'III,hI rep-lilted _ ' "  !hal the  JOUrtC IS ~Ied  Contents Page 1  The Long-Run EjJects ofa Permanent Change in Defense Purchases Mark A. Wynne  In this article. Mark A. Wynne explorL'S how a pcnnanent  n:GlI(.1ion in ddL'JlSC spt.'t1Cling I11ight afft.'(.1 the aver.Jgc u.s. household. !-Ie finds th,ll, in the long nm. American.. willl'e'dp a peace dividend For example. if Congres.s n:<.iuu:s a nnual defense spending from 6 (kfcent of gross nation;!! prooud to 3 pero::n!, in Ihe long mn private consu m ption as a share of GNP could  rise 3 percentage points. In the ... hon nm, some husinesses and hou ...c holds will slistain losses. Over timt:, however, the economy will reabsorb tht.. n.:soun:es frt..'\.-d by lower defense-related pnxiu(tion and will exp:Lnd production for priva te consumption. Underlying Wynne's analysis is the assumption that Congress will lISC the funds s:lwd on d~fe nse spending either to lowcr taxe:; or to reduce Ih(;.· deficit Wynne develop:; a simple empirical modd to expl:iin the relationship he tween the sh:m! of GN P spent on private consumption a nd the s hare spent on defense {)vt:r the past one hundf(,'d years.  Page 17  Europe 1992: An Overview linda C. Hunter  Thf.' Europea n Community (Eel has cmha rkt.-d on a progr.lln popularly referred to as Europe 1992. 'nle aim o f the program is to achieve :1 unifk.-cl Ellfopean ma rke t that will overcome the economic slagn:.tlion and unemployment of the early 1 9HO.~ :md improw 111<.: pOSition of EC members in the gloh:J1 f.'conomy. In 19H5. the European Commi...;sion proposed almost 300 spl!cilk I\:forills thai would reduce tmde harril!l":i bdween EC countries by 1992. By July 1990, the Commission had begull negotiations on 60 percent of Ihese reforms. and many of them have al read y hee n adoptl!u . Linda C. Hunter examines the kcy measures that will contrihute to European (;.'Col1omic intcgr.ltion. She points out that whilc the gains frolll unification may he large. unification will hcnd1t counlrie:-. in the interior of EllfOpt..'-SllCh as GennanY-lllorl! than EC-memher nations on the pcripherys uc h as ponugal. Spain. ;ll1d Gre(;.'Cc HlInt~r ooscrves th;\I the (;.'ountrit:s on Europe·s periphery 1ll:IY IkCome d iscoumged and delay the pr<X"ess of unificalion She concludes Ihat while the EC lllay not mt'et all it;.. goals hy 1992, il will have made Pf()Wt:S.~ in lil)(:'r.. l izin~ its internal trJ.ue. making Europe more inte~r.l h..-'(I than it W;IS in 19H;.  Mark A. Wynne Economist Federal Reserve Bank of Dallas  The Long-Run Effects of a Permanent Change in Defense Purchases  D  uring tilt..' fin_t half of 1990. there was widespread specul:l1ion thaI the recent easing of East-West Il'f)sions would allow deep nL1s in lhl' defense budget I'l"Opo.'als for cutt ing Ihe defe nSl' bllcl~el I~!!l).tl'd from a 2-pcrcell1 nit in real terms each year through fiscal 1995 to a halving of the defense budget hy the end of the dec;ldl', Dl'wlopmt:nts in till' i\liddil- East in the second half of  1990 te m pered the lIIorl' l'xtrl'me propo.~als for cutting (Il·fe n:-..... spt.;nding, hut these clevdopmenls !>et;m Iih'ly to (1!..'!:Iy the hudget-<lltting pn:X:l'SS only tt.'mpor.lrily Till' impk:menled CulS will gt.'nl'r..lIl· ;1 PC:ll'l' dh'idend til:1l will benefit Ihl' a\'t'fagl' Alllel'iCl1l iltlu:-.ehilid. T hl' Ill· ..,i:-.tent hlldgl'l ddkils of tht: fe(il-r.11 gO\"l.::rl1llll:"nt O\'l'r till' 1':1 ...1 dec:tdc are also pUlling pre:-.:-urt.: on Till' dden.",-· hudget At p resent. ddense pllfcha.'>Cs ;l(.'l·0l1ll1 for :lhOlil 75 1X'f<:l'nt of 10t:11 purcha.'>l".' of ).:ood.... and servin:s by thl' fede r.11 gm'l'fIlllll'nt :Ind ahout 33 pt:rct:nt of Total purch;l:-es of ).:oods and :-'\:!"\'ices by ;111 Il'vd:- of gO\l'fI)l11l.:nt flka:-urL'd in 1982 dollars, <k'fl'rbc purclla:-c:- grell :-tl':rdil y fr(lill a low of S I ')7.:; billion in 19"76 10 S16') I hillion in 1987. Sincl' Ihen. ddense ]1l1fcll:I., e:- hal'e fallen in ft'a! Tl:"rms to S2,)() .i h illion in Il)Hl) \X/illl the udensl:" hUUgl·t I(xmlin).: ... 0 I;u').:e i n till' o\'t:.·r.rll spending plans of Ihe feder:11 }:ol·l·l'!1menl. il is nOT sllrpri.... ing thaI l he <kfl'll"<.: hudget is vil-wl'(l as a potential sourcl' of s:tl·in).::-. that (.( Iltld Ill' applied to thc dd"icil fl lo:-.t di'>(·ll ...... ion:-. of Ihe peace divicil:nd Ih:lt \\Ollid al'l'Ompally a !'l,<lu('(ion in dcfe!l:-'c purchast.... h.II'l' hecn :-,o!lle\I' h:11 v:l)::ue alx)\11 Ill(" n:lIllfl' ot Ihl' lll."nd"ih of :1 :-.m:tllt:r dden"e hlldgel I ("on'ltk'r .1 ]"Inlier dl:lngl' hy w hich the ";ll'il1).:." genl"I~IIL'd h~ 1(l\\l'r ddl·n... e pllrc ha~e:-. aI'''' u"l'd to lo\\\.'r hOll:-dlOld 1:I\l· .... o r l,<\IIl\'ak'nTly, Ih ..: Economic Kn'i,,·w-Ja nuar), 1991  budgel deficit. I arguc thai :1 pl'nmmcnt redUCT ion in ddcnse p urchases w ill make thl.' average U.S. ho usehold beller off by hlx)sting its consumption and It:i.~urc. This re ...ult is firsl (kmonstr.lled in a simplt: theoreTical mock'i in whi<:h defense purch:l.~es yidd no dire('1 henefiTs to private households or firms. Thl' aVl'faHe household is l11:.1de l~lter off hccaust: it will pay fewer taxes 10 finanCt-' defenM: purchast'.~ OVl'r tht: ('ourst: of iL<; Iift.-. The ~lllal1er 1:1;'; burden r..rises household \\'("alth. enahling il 10 e njoy hi).:hl·r It:\'els of ('on:-ulHpTion even while \\'orking ft.-wer hou l'S. To quantify thl' henefih of lower defense purchases. I focus on Ihe gain:- in private conMllllpr ion, The permanent incom..: hypotht-'Sis Slates Ih:lt a penn:lncnt retiu("\ion in household taxes will lead to :1 matching penn:m..:nt increase in household <:on.~lImption. By allOWing household.~ TO c hoose how 111\l<:h to work, 111y theorcliGil mouel rredi(·ts Ih:11 a decrease o f I percentage pOinl in the s/)a/,(' ()f ddi::n:-.l' pun.;h:lst:s in gross naliona l product (GNP) would k:ld 10 an increase of I pel'l.:enlage point in ,h..: sh(/re of private consumpt ion in GNP I t:x:lllline tl1(' relationship betwecn these t\\'o shar..:.~ in a ... imp!e empirical mrxlcl and show that Ihe predictions of the theory arc consistent with the' (·xpt..·ril-nct: of The Un ilcd St:tte:-. uver the P:J:-I hllTldrl'd years My l'mpiric:1l Illodel predict~ (hat rl'(Judng the size of Ihe dl"fense budget from 6 percent to 3 percent of GNP will :Idd 3 rl'rl"t~n lage points TO the share of  I 'MSh klltlafl/C Jo&epII H HasIag. Jchn K HII. and Evan F Koet'rIg fr:Jr uscItJconmenrs Anye<r()l$.I'Iowever. aremyoom  private ,-,onsumption in GNP. Thus, even;1 reductio n in the size of the ddense budget that is not accompanit:d by any other major policy change will yield signific:.lnt benefits to the average American ho usehold over time_ Fin:llly, , address tht: issue of whether there is a relationship between the I<:\'cl o f defense purchases and the growth r..ue o f output in the long run. The model I use to analyze the dfeclS of a penn;ment reduction in ddense purchases does not allow for such :1 relationship. I hriefly review sevemJ swdies Ihm have tried to d(:termine whether such ;t relationship exists, and I find that the evidence is ambiguous. In the light of this fin ding, I arg\le thm ;1 cut in defense p\lrchase.~ in and of itself is unlikely to increase the ~ rowth rate of output in the long run.  Figure 1 Share of Defense Purchases in GNP  Defe nse spen d ing in t h e U.S. economy  from a low of 4.8 percent of GNP in 1978 to a high of 6.6 pt'rccnt in 1986. Since 1986, defense purchases have fallen steadily as :I percentage of GNP and are projected to continue falling for the rest of the dt:cadc. Figure 1 provides a historica l perspective on the signific;1m." c of defense pUf<.." h:lscs in the U.S. economy. The fi gure summarizes the hehavior of defense pur<:hascs over the past hundred yC""d.fS ;lnd illustmtes two points . First , there arc fou r dear peaks in the share of defense purchases in GNP. which ;!fi:! associated with tile major wars in which the Unitt.--d SI:lIeS parti("ipated during this period: World War l. World W:l r [I. Korea , and Vietn:lln. A less distinct pe;lk :I ppears in conjunction \vith thl;' peacetime defe nse huildup in the 19130s. The wartime peaks in d efense spending arc esscnti:llly tel/lporal}' phenomena because defense purchas\:!~ are always cut dr.:lsticall y ,It the e nd of each war. Figure I also illustrates th:tt, whereas defense purchases fell to Iheir prewar norm in the :Iftennath of World War I. a si mila r contraction d id not occur following World War II . Defense p\lrchases <lver.Lged 0.7 of 1 percent of GNP over 1900-13 and 0.8 of I percent over 1922-29. As already noted. defense purchases ;1\'er.lged 7.4 percent of GK' P in the postwar period. In essence, there was :1 permanellt incre:tse in defense purc hases in the ;Iflennath of World War II , which was associated with tbe rise of the United States to superpower staws and the outbreak of the Cold  [ have already n()(ed that defense purchases of goods a nd st:rvices grew by more than $100 billion in 19B2 dollars between 1976 and 1987, ;\Od in 1989 defense purt:h:lscs t()(:lled S256.3 billion. However, the absolute level of defense purchases is less importa nt than its m;lgnitude rd .. tive to the tOlal volume of economic activity. A good measure of this relative magnitude is the share of defense purchases of GNP. In rdative terms, ddense purchases were 5.8 percent of GNP in 1989. 1 Over the postwar period 0947-R9). defense purchases a\'c.:raged 7,4 percent Df GNP annually, althDugh this aver.lge masb:l fairly ste;l(ly decline from ;t peak of 13.2 percent of GN P in 1953 to:J low of 4.8 percent in 1978. For com parison, dclcnse pu rchases reached a n alltime high of 41.'1 pt:rcent of GNP in 1944 at the height of World War II , :mel they were 16.7 percent of GNP in 19 18 during World War I. The mil itary bui ldup associatcd with the Caller and Reagan adm inistr.Jtions took defense purchases  , Thts Sl'lafe IS tho ra"o of nom'na! defense purchases /0 nomooal GNP Measur"", /tie Sl'lafe /his way .ather /han as Ihe rallO of real defense purchases 10 reaf GNP means /hal changes on tho rc/abve pnce 01 defense purchases will be p«:kco up es changes in /he sha.eol dcf(!t1se purCltsses If)  GNP  ,  45 40  35 JO 25  20  " "  05  18.\8~9~'~B~9~9~';;9;;09;o?";'~9"';;9;:2~9:;';;9~39;-;-".4"9""9"5'9~"9;;69""""7;;9,,;9o89  fcckral Ro:sc:rvc Rank of Dallas  W:IL The easing of Cold War tensiom. since 1989  h:LS neated the possibility of:1 permanent n::duction in the le\'cl of ddense pLlrch:lscs in the fUIU1'l". I an:llyzl.· tht: likt:'ly consequences of such a pennanent dlange below ~ Now th:n I have discus. 'it..-d the signifIcance of defen~ purcha.'>I...'S in o\'l'r:dJ ...-conomit' :Iltivity. how important are ddt'1lSe purchases in tilL' budget of the f\..'der:11 gO\'I.'rnmcnt? Defense purchascs of good", and .o;crvio.:!'o is by far the largcst category of purch:lsc!'o in the f...-deral hudgL·1. For example, in 19H9 tOial f...·der:11 government purch:I."<-'s of g()Q(l.. :lIld .'>Cfvices were 5400 billion. of whit'h S301 I hill ion wcre puri.:hases for n:L1ional defense·1 For comparison, tot:11 purchases of gOCK"" and services by :dlle\'c!s of govcrmlll:nt in 1989 were 51,025.6 billion. Thc catq~oly of def...·nse purchases in 19H9 W:IS plln:ilases of services. which totaled $203 j billion Induded in thi.... euegory an: com[X'n",at ion of mil itary rcr....onnc! (S713.H hillion), (.'{Hllpcn.'i;.lIi()Il {)f civili:ln cmployet.'S of the defense depanment (S40 2 billion), and a ("',llt'hal! Mother :-.<::rvice!o" (S&1.3 billion), which CO\'e,"", sllch items as p:lyments for contl'<lctual rc.~,lrch ;lnd developml.·n1. the opcr.L1ion and nl:tinlenance of military in.-.talbtion'i, :md v',lrlOUS comull:mts' fL'C!'o Purdl:l'iL'S of dll!':lble goods (!'ouch :t.'i ain:r:lft, ships, and tanks) an."olmtl.-d for 580.9 hillion of \<)(al defcn'iC plll1:hasc:-. in 19H9 PurchaSL's of nondur.lhlc good... (such :1:-. pt:lmleum pr<xlu\..b and ammunition) at'CounlL'{1 for S 10.4 hill ion . :md purcha . .es of stnlChm.'S :I("counted for $6.4 billion I wil! shmv that the composttion of defense purch:Lscs is of some inlere"t in tenns of thL' shon-nm crft:cts of hll(l~et nits, hut it i. . of less inteR.'st in the long mn. The likely course or defL'nse purchases over th .... next decade has been the subject of much . . p ....culation in lh .... light of reCL'llt political devclop1ll\..'llts in Ea . . tern Europc and the Soviet Union. EVl'n wit hout these (\(.'vdopml'nts, ma ny obselVers considerL'd the dd't:n . .e hudgct to he a prime c:lOdidate for cu1.~ tllat would ;llleviate Ihe fedcml g(l\'ernment"!'o hudget.try pmhlems. It i. . very Hkdy that the military l''''wbli . . hment will be !'oGLIed hack from the le\'d" rL'adlL-'(J at the height of the C:.Lner-Re.lfPn ddenS(.' hUildup; the m{).,~1 r,ldical proposals envision a h:ll"in~ of the ddense hudgct hy thc turn of tht' <:enlu!)'. It should be n:membert..-d" however, thaI cutbacks have already hegun. Si nct: 1900, Congre:-.... h;lS cut the defense Economic Rev lt.- w-J:lIlluary 199 1  budget in real terms hy alXHlt 2 percent each year. In the hudgel for fisc;ti 199 1 prescnlt.-d to CongreS!> at the beginning of 1990, the Bush administr.u io n pmjeclL'<.i annual cuts of the s:une magnitude through fiscal 1995. However, in the o pinion of most analy.':>ts, !ollch projections are a lowt'r hound on what will actll:tlly tmnspire.  Modeling the effects of defense purchases theecooomy  00  To assess the conseqltence.~ of:l pennancnt reduct ion in the level of defense purchases, il is useful 10 begin wilh a simplc analyt ical model of thl: m:lcrocconomy.' Consider an economy in which final output i. . produced using a consta nl returns to scale tL'chnology C:l pita1 and I;lhor are Ihe only inpltls. Both inputs are productive but are suhject to diminishing returns. The :L\'erage house hold '·allt ....s hoth consumption :md leisure, and additionallillK' spell! working directly lowers Ihe alllOllllt of leisure time available to the hou~hold. Tho.:: houschold abo values consumption and leisure in the fulun:. so it doc'S not ignore the conscqut:n\..·c::s of :lCtions taken today on future consumption and leisure. The household ha . . a positive !':ttc of time prefercn<.:e. meaning that consumption and leisure in the pcc!oent arc valued more highly than consumption and leisure in the future. For the s;lke of simplicity. I will assume that the produL1ion procc~ is dinX.1ly ownL-d and opcr:uL'{1 by households, so the saving decision of tht: household is the same :IS the inveslmenl decision of the fi nn ~  , For an analySIS of tho olfOCIS of temporary changes defense PUlChases aSSOC!8Utd wah WfllS usmg thc  In  same  model. sec Wynno( I~) Note that/he model predlC/S /hat tcmporarycl'Iangcs In dcfCflsepurchases havenolong·run eff9C1S , All figures are fr(Y() /he US Department 01 Commerce's  Sorvoy 01 Cunent BuSlOCSS. July 1990, fable 37 8  • The mcxJcI used hete IS a Standard neocJaSSJCal model and IS discussed a/ grcater /cfIgm.on BaffO (1987). chaplet'S 2. 9. and 12 • The  1I~1Ofl  01 CO'7¥)CMIVtI markets lor goods and  factors would not alffler /he analysis  rhar follows  St:J l l'{IJO .. U£1l ....U ,x.llf Iru.lp;t,1 01 p.l.1IlPU!  ''XI 01 ".l.llllh;lJ I! lIOllthun"UO.l p:UOII .Inol[ ;lJOUI .lllll :"IUl:'jJO.\\ HlOJJ  tl'.'}-I- ( V'X H "'.?  • (II  -!PPI: .-llP ... [1:11\).1 1,,"1  p:"l  lll:.} I! 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It: .\llI()U().l."1  ..., ....'l"I:tp.ll1d .")';u'"),PP)O 1;).\·"'1\ .1'l.l ·IU."'Iltl\...."1 \Ill ~''''IJJ<I ...ll(JU.)PI plll' 'IH)i ldlllll"'wn ...."I\I)\l."'Ip:J ,"'1.1."'1'1.\\  "'!I[l  JO  11Inpq!!!l1b."'1 ."Il[llo·;)II!.II"nw (."'I.lnii1:1  ....£1 + I  ~  N  g (N ' ~):l  o Wn!JQ!I!nb3  l eJodw91eJlUI  c:: 9mB!:!  work one more hour. The "ddition:11 conslLmption the ;lver.:lge ho useho ld H.'quires to be induced to work o ne more hour is l:J.C - - U,( CN)/U( CN) l:J.N, where U,(CN)/l ~ (CN)is the marginal r.He of substituTion between (:(lOsumption and \vork effon. The utility-maxiliiizing combin:ltion of consumplion and work is given by the requin.:ment that the marAinal mte of substitution Ix:tween consumption and work effort is equ;:d 10 the marginal product of labor, and is w ritten  Point £ in Figure 2 ilIustl~lIes this equilibrium, with the :~er.lge hOllsehold consuming C and supplying N ho urs of \..... ork Because the :\ver.lgr.; household is forwardlooking and derives utility from consumption and leisuft:' in the fUlure as well :IS the present, it will 11lso decide:n cadi point in time ho\V much to invest The size of the existing capital stock relative to the o ptimal c:lpit:ll stock, K', determines whet her tllere w ill he net investmenl or disinve.stme nt. [I' K is 1<.:ss than K'. there \vill he net investment: Ihat is. the hOllsehold will add to its capital sttKk more than is net'ded to re place capital lost oceluse of th.:pfeciation Over lime. the capilal siock is adjusted until it equals ils optimal long-run lew!, K '. The oplimal Clpit:d stock is detenninL"<.1hy Ihl.: requireml.:l1l that Ihe Ilt'l marginal Pf(XIUCI of capital ....qUlII the pure !~I{t' of time preference lkGluse of the assumption of constant returns to scale. the optim:llit)' condition thdl d .... tenllines the capital stock Gm also be thought of :is detelmining the c:1pit:tI-blx>r ralio. 1\." Thus. (3)  whe re p is the pun: rate of time preference. Thi.-; equation says that thl.' household accumul:nes Glpital up to the point where the increase in future consumptio n obt:lincd by increasing Ihe capit:11 Slock by ont· unit, l:J.C; ., .. 11:( /(.1)+)- OIl:J.K" just equals the incrcasl.: in future consumption Ihal the household requin:s to [)t! induced to save (in other words. not consume) one unit of current output. l:J.G;., .. ( 1+p) (/,( C;. I\; )!U~( C,.,.N, _, l6K,. In long-run. or steady-.... ta te. r.;quilibrium. consUlllptio n and work dfort are constant and Economic Review - January 1991  equation 3 follows Hi~her rJ.tes of time prefere nce, p, or depreciatio n, 0, w ill lower the capitallabor rJ.tio . Lpward shifts in the marginal productivit y of capital schl."<.lule, I;~, will r.ji~ the t':lpita[- labor ratio. The ternlS of the long-run trade-off octween consumption and work effort are given by the fo[lowing relationship: (4)  C = N IF(K,l) - OK] - G'1if.  The ratl' of depreciation of caril:lI. 0, and the level of defense purchases, G'~i, are de tc nnined independently of household decisions about consumption and work effon, so the long-ru n tmde-off between C a nd IV is linear. Higher levels of defense purchases cause the trade-off 10 shift down p:lmllel to iTself. Changes in the parameters that determine the Glpital-labor ratio, such as p and O. cause it to c hange slope. This lrade-off is the line 1.1. in Figure 3The last thing to be determined is the comhinatio n of consumption Jnd work effort chosen by the household in steady-st;lte equilibrium. To do rhis, note Ihat there is a unique real wage, or marginal product of labor. ass(Kiated with tbe unique steady,slate clpitallabor ratio. given by ( ;)  This real wage ddines an Olilput-expa ns ion path, giving the combinations of consumption and work effort chosen by Ihe ave rage household al this re:il \v;lge for different levels of investment and defense spending. Thl' output-expansion palh associated wilh the sleady-stale real wage is Ihe line PP in Figure 3. This line begins at the point representing the total amount of time available to the average household when making consllmp-  • (he assumptJon of cons/ani returns 10 scale JS SJmP/y another way of saymg that Ihe produc/J(JII func/J()(l is hQ. mogcncoos of degree one in K and N Homogene,ty 01 rJogroo Q'lC means Illal F(lJ< l.N)=l..F(K.N). where .. 's any p:!SJ!JV9 real number 1/ can 00 shown that thc parTIal dcmvativcs of a functiQt1 that JS homogeneous of degree one amhomogCflCOUS ofdegrcc ZfYO Thus. F.l"K ..\N). FJK.N) '" F.(KlN. l) .. F). ><.1)  ,  Figure 3 Inter1emporal Equilibrium  c p  c·  L  ------------  N°  p  N  L  tiun :Hld invcstnll'nt d eci .. lons a nd .. lop...·.~ lip from ri}:hl to left hccau ..e hot h ....onsumption and kbul'l' .Ire no rmal }:oocl!'o. T here is an infinite rll.llllIX:r of .~ il n ilar ()l1lput-expansion p:llh ... :1."s(Ki:lll'd w;lh different I'e:ll wage !'ales Tho:-.e p:llhs lying :il")()\l' :md to the right of PPal'(;! :tssol'1:ltcd with hight:r re al W:lgt: fat es, while those p:nl1s lying lx-low and to the It:ft o f PI' are :tsso<:i:ltl'd with lower rl'a l wagi:: rates. The :-.1i:::ldy-st:lIe choin's of ('on s umpt ion a nd wo rk dfon a fe determincd hy thc intersect io n of this line wil h the IJ. lilll·. At thi!'o  TIle onlY dyr/8mICS ill/his model are /hose ans'f1f1 from lhe /evel to ,IS dcSNed long.rtJ(I level The tnCluSlOil 01 growth due 10 exogenous Isbot·augmetllittg /cchnlt:alprogrcss wouIdnol 1r8t'lSl/JOn oIlhe c;llP,rtJ/ s /O(;J( ' rom sane ""Ira!  malc" a lly aller tho analysrs  6  point. till" l'l'ollomy is in lon~-run equilihrilull. or :-.te:ldy·:-.t:ltc cquilihrium. in wlul'h all the dyna mic..; a...;sIK·lakd \\'ill1 the ('onn,:rgl·ncl,.· o f the capital :-.1ocJ,; 10 its 0[1tim:l1 ...;tl·:ldy-:-.lalt· le\'d havt: cl':lsl'd .Figure 4 t'olllbinl'." Figures 2 and 3, showi ng all the detail s of Ihe sll.':ldy-st:lte equi lihrium . This l'qu ilihriutll is at till' r<)int It. and the requiri::l11ellts of both :-.hol't-run :1I1d lo ng-ru n equ ilibrium ;\rl' ";:lti:-.fil.:d . To[;tl Olllp ul in th is equilihrium is di vided hl·[Wl.:t·1l tl1fl· .... lh ....!'o: l'()Il,"ll lllpti(lIl. investme nt. ;llld dd\.'I1";I,.· pllrdl : I .~ .. Tht' a\'i::r.1gc hOlls..:hold b l'Orbllllllll).t C" a nd d C\'o ting 1\" of ils lime \0 work ...-Ilort. Thl:'fl' j .. no nl.'t irwt'stlllc nt in [hI,.' "[l'ad), SI:lt ...· o ll his model AII .. tl.':ldy-.'>t:l1e im'L'stlllt'nt i:-. n.:pI:Kl.'m .... m inn:::-.tlllt'nL which is simply 15"··. whl'rl' " .. b 1he :-.Icad~'-.~ I ;l1e GlpiTal<:1.: as dl'll·1'Inir1l.'d In' Illl' inll'r:ICllon o f tht: ..!Ie l'cdcr.1.I Reserv., \lan k o f Dall as  Figure 4 Long· Run Equilibrium  c  - -  -  - -  - - -  - -  - -  -  -~--~E'~-  c·  N  of tillll.: prt:fL'fl.:lKL' :!nd tI lL' marginal producti\ ity of ca pi!:iI , Fin;lt!~ . tho.: ,'h,::ldy·~t:lte 11.::\'c l o f ddcn.~L' p ll rch:I'e,' i, (,",Id A qUt.',uo n Ih:1I n:llllr:dly ari'l:s i~, Ho\\ l':m r 1'1.lft.- Olll Ihl: pOUlt R;I' a ~t t::ld) ·~t:He I.:qllilibrillln~ Co m p:lrinJ.: P!O I:", il i, ckar that t ilt: an.'r.tgl.: hOll,ehold i, lI ll;l lll biJ.!lI()ll ~I~' IlI;!llt::r o lT, no! only con"ullling Illort.' lIn:tl OLUplil hu t also \\"(nklllg more lit." " I)()\ t.' Iht., :.hon·nln produL1ion fUnl't I(1Il : t ~'>( )(:i:l!l'<.l \\ ti ll lIlt:" ~\(,;td Y·"I:I\L' l':lp it:tl ,tock, A' , and j, Ihnt."fOfL' o n ly aUain:lbk' hy mnmn).: do\\'n thL' (,,;,I pil;[l ,t()(.'k, ' 11k' nCL'd to di,,,,, in\'t." 1 for j::tn IX';1I1 L'qu ilib nulll 1llt::tIlS il l':l nn!)1 Ix: .'olt'lained ;IS :1 11 l:quilih rill ill i n thl:' long nlll  r  F.oon o mic R",v;"'w -  January 199 1  A permanent reduc tion in d efe nse purchases \Vhat h:tppo.::ns if tht: j.!()\'l'rnmL'llt rL'duces tht: stL,:tdy-,,>wte k'n~l of ddc!lSl' pllrL'h:t,~:.? A reduction in stl:'ady-sl:ttt: (k-fcn!ooL' pllrch:lscs in this modt:l is II\(..' :lIl:l1ytical olUllInp:1I1 of thL' '>on of pt:on:l11(.'111 rt.'<.luction III tilL' lk:tl:n..;c h udJ.:L't th:L1 is nlrrcntly under considt:r:.tlion. Fi}l.urc '; iIlustr.ltcs the ctTL'ClS of ,>uch ;t {'ut Tht.: long-run trade-off Ix'\\\(.'cn COn.'>llll1ption and work t:fli:>n shifts u p 10 ibelf hy tht.: amount of the rt.-'(iltl1ion in ddL'nsc pllrch:I!>c~, fl O M , ·n ll:- .. hift (X' hecause  the fall in demand for final output ror defense incrc a:-es the amount  or OUlplU ;t\':li]:thle for  ,  Figure 5  A Cut in Defense Purchases of Final Output  c  N  COI'''U11lPlil III al L'\'I.:I)' 1<.;\'1.;1 of work dli)lt 'Ilk: .~ ltOI1 rlln 11~ I{k' -oll IX:lwo.:o.:l1 corbll1nplion and work l:ff()11 also .. hilb up par:lllci 10 it.,clf hy Ihe :llllounl of Ihl: rnlu<.:(iol1 in do.:fl:l1.w pun.:ha.w ... It :l l..... J sh ifts lip ;Hl addillonal amount. AU. hL'cllI:->e .... )111<.' of thl: surplu:-> <:apilal 111:11 j., no lon).tL'r llcnk-d to producc dden ...... )..'o(xb GlIllx: u",-Xllo aug11ll:1l1 t1.11l\.·1l\ O)lhlUnplion, ThL' L>(Ul1olny mO\'L':-> 10 a :->holl-nm L>(jwlihnulll :n /:'" where IhL' ;t\L·r.I).tL· hou ..ehold i .. \\'orkin).! fl:wn hour. :rnd llJn..umin).! 1l10fl.: Ih:rn al IhL' inili:11 L'qUIlihrium J:" O\'L'r timL·. thl' capItal ..Io(:k 1:-> nrn do\\·n. and the L"(.UI10IllY mO\L" tow:ml tIll: nl:\\' long-nrn l'<lllihhrium :11 /;.- In Ihi:-. l:qllllihnulll. 11ll' ;I\'L'[;I/-:L' hOll,dll lId i.. llnamhi}:lI()l.I .. ly 1'11..'110.:( (liT th:rn at J:". \\urkin).t fewl'f hu,n" and (UIl.... I111in).! mort.: 1111;11 {M.llfM.ll 8  Tho.: ini llilioll for thi, rl:sult i... 'lL~ l ighlf()r\\,;lrd . A p.:nll:lI1Lonl rL'dliclion in Ihl: k\'L"! of ddi.:ns..; purd l:l,"o.:," III' llnal {)1I1p111 inLTca:->c." h( )lI,dlllld "'0.::11111 hy lo\\L'ri nj.! iI, ('llrrL'tll :md tlllllfC I:IX hURkon. Thl: a\·o.:r.I).tL' hOlIwhotd 111I.: n 1I......:->lhi,.. HlLTC:I:-.o.:d \H::tlth I() fin:lnL'L' incfL';I'L'd t'lrn .. umpIHln pur('h:I .~es {If 11nal output :md int'rLoa",-,<1 k,j"lIn.:  A permanent reduction in  defen..~  manpower  Fi).:lIrl.: .:; ;11'0(1 Gm I'll..' u:-c.'t.ito illu, Ihe dli..'t.1~ 01 ;1 L'ul h;rl: k III (k.:I\:IN..· rllrd l:lM~ Ih;lt takes  IhL' fonll 0 1 rL'(llIo,:d manpower f'I,:quin..°lllent... [;llher Ih;Hl ro..'(llI(·L>(1 pUfl.: ha:-c:-> of 1.11:11 mnpul TIll" Ion/-:run .... tk't.'I'- of IhL'I\\O nil" oil'\..' qualil:ui\'dy simil:lr. fcrkral Rese ...~ Bank of oaUas  Figure 6  A Cut in Defense Manpower Requirements  c  E··  E,  E·  N  but till'  .~h()11 -rtin  dlL-Ch dirk'r .\Iilit ll'")· t:mploymi:nl :l.~""lI min).: ,h:lllh<.· ;1\U":I).:i: hou ..dlOld ~pi:lld~ p:1I1 of it.. lilll~ in tIll' milu;II'")' :md 1':111 of ih I1l11l' at priyalt: produClIH' :lcll\·lIi<.·.... Thl' :1).:.~a·).:: It'-' nnplicltion:o. o( this ;ISslimption :m.: 110 ditf"·I'<.·nt from a~",ul1lin).: that ...OIlK· hOll.'>C... hold.... "'I)I.'nd alllhdr time \\'orkin).: (or thi: mililary, \\hik 0111..·1.......]'X:nd :rlliheir lim<..' working in th,-' pri\,II'-' '0(.'(,101' Figllr<.· 6 i llll ... tr.ltf.·..., till' d l ...·l·h or a n.:dlll·lIoll III tIll' Illl1nlx'r of hOllr:.. Ih:lt tIll..' ;In'r:lgl' hotl"l'htJld Illll ..1 \\ork (or tht' milit:u'") '1111.." lo ng-mn II":td..:-()fr 1)o.'1\\ ...·':n nm ...lIlllpti<lll :Ind \\(lrk d lon ...Iuti ... 10 1110..' IL'ti p:u:dld 10 il'>t."l( h~ II .....· i.~ analyzl'd in  ' Ili" Illodd by  Eco n o m ic Kl""i".., - Janu ary 199 1  alll()llnt ()f lilt' n::<lucli(lll. 6 ,\,""'. Tilt: ,.. ll(Jn -nln tradeo!'t' also ... hift.... to the I,... ti p:lI: dld to i1...<.:Ir by the .'i:ll1lC amount I [o\\'t:\'er. Illl' ... 11011 -n.1I1 tr.l(lc.:-otT :dso shifts down P:lr.l)lclto I(.-.ell hy an :1(klil ion:11 amount. All. TI1i: n.. a."<m ;... :1.. 1'0110\\ . . Till' pennan.... m rL"t.llIction in till.." manpowe r r..:quircmL'nt .. of lIu... milila!]' inaca'>t.".., hOll'>l.."hold wC:llth :1.'" lx:forL'. Unth COIl..urnption :tnd Idstln.,' im:rea ....... :tnd lot:11 hOllrs of \\'ork d<''Cfl'a.-.e Blil tim ... ,,]'X.'nl \\on.:inj.! in thl;! P1W;1l1;! "l'C10], will im:rea"l'. r:l i .. ing tl'M.:.· marginal pnxillcl of <.':I pit:rl :tnd th ..' "'''':ld),-SI:III..· l':lpit;11 stock '1110.: :t(khlion:l l iO\C"[IllL'll[ IlL·1x!...'t.lto lOcrease [he ..,I ....ady-... t:tte C': lpit:tl ...IOL:k 11'lllpor:l ril y \\'or~ns the  •  .~ hoI1 -run  <"'(IIlSlllllpti(1Il J')(J:o.sil)ilities of tht:' ;1\'(:r.:lg<: household htlt improves Ihem in the long run. An inil ial t:tjuilibrium is t::-.t:thlishcd :1( /;~ wilh increa~-d priv;ne-St.'<.1or employment and lower consumption. On!r time, the economy movt:S tow;m.l the new kmg-nm equilihrium. E-. wllere again the ;IVer.lge.: houSt:hold is Ix.'ttcr off than al the initial <..-tillilihrillill. Jr. wilh higher levels of consumption and lei.. . lIre. The inillilion for this result is Ihe same as that for a pennant:nt fI:.'duC1ion in defense purchases of fi nal output. I lllodd military sclVice as a lax in kind. A penn:lOl'm l\.-tltK1ion in the manpowl'r requireml'nts of thl' military lowers the la.\( hunkn of the averagl' household, thereby increasing its wealth A.~ lX'fOfl'. Ihis incn:::lscd wea lth is 1.Isl'd to fi nance an incrcasl: in consumption and leisure.  Comparison of the poUcJes Uoth cuts in dcfl:llsc p urchases of final ou tput and cu ts in military manpower n:quirl:menls incre.:a.'>(; thl' consumption and Idsu re.: of I he aVt:r.lgt:' houSt:hold. Ilowcver. the implications for otht:r quantitil:s ;lOd prices in the model are diffl:rent. Whert:;,..; a permanent reduction in purchasc-s of final output pUIS downward pres:-.ure on reat inu.:rt:'st r.:1le.:S :lnd UpW:lrd pressure on real wages during the.: tr.In . . .ition to the new long-rull etjuilih rium. a pcnn:lnelll reduction in manpower requirement!'> has just the opposite effl.'Ct, nl ising real interest rates :lIld lowe.:ring real wage .... A cut in purchases of final output rtc'<.lllces labor supply hy r.:li...;ing hotl...;dlOld wc:tlth Firms nCl.-tl to pay higher w:.lge...; to rct:lin workers as thc cconomy '1CIjusts. Incre:I...;e.:d hotl ...;chold wealth also lowl'r", the optimal capital stock. putting downward pressure on rl::,l intert:st r.lles while the ca pita ! stock is run down to its new lo w er level. A reductio n in dde n...;l' m:lnpower rcq uin:mcnts rek'ases extr.1 worke.:rs imo the labo r m arket. putt ing downw:l fd pressure on real w ages IIo usehold we:l lth i nne:llit's, but because mOI'l: effon is now (\o.:\'ot e.:d to private productivc activity. the optimal stt.:ady-sl:ue c:lpital stock is higher 1111': tell1fX>r:lry !'>hortagt: of productive  .  capital while the capital stock is built up to its m:w higher level PLits upw:trd pressure.: on rl';11 imeres[ nltes during the tr.:ll\sit ion. Tahk' I ~lImm:lrizes the n."'Sulls of Ix)(h policies. For rt~.ll wages and imcrest rates. I distinguish ht'lwet:n shon-nm and long-nm efftX1!'>. 111e :Ihs\"'nct:' of any effet1s Oil eithcr of Iht:s,,: vari:thles in [he long nm is a dirt.'<.·t implk':ltion of the assumption of a coru.tam-rclurns-t(),,~·ale tccllllolog}' A..... I h:lve :Ilrc:.ldy noted. the a . . .~umption of const:.lm f<..'tllnlS 10 SC:lle means thai margin:ll prOdU(1s. and thus real (:I(tor rcw:tr<ls, aTl': (iL'to.;Ill1intc'(l solely hy th<..· Glpilal-bhor r.:llio. K. BcclU.'*-' changes in dden.<;(:: p urchases o f final o utpllt and military l1l:mpower do not affect Ihe steady-st;ttl: of K . neither wj]] they affcct real wages or re:ll interest r.:lles in the long nm. 'Ih: different shon-run eJfl:ct!'> of the two policies ;Ire C11.lci:lll y depen{blt on the o.:bsticity of IalxJr supply. Furtlll~nnore, they arc probahly Ie.';."; significant than the long-nlO rcslxmse of privatt: olnsllmption pun.:hascs 10 :1 pcnnane.:nt re.:du<..1ion in dd<"'nse purch:lscs. In what follows. I will l(x)k only :ltthe historiGtl relation"hip 1X'lw<..'l.'n defense purl'haSt::-. :tnd private consuillption pllll.·hases hecau:-.c till' pfl.-tliClion thaI Ihl:-. relationship L..; neg-dtive i...; mort: rohll:-.t 10 various ch:l n ~tc-s in the model tha n arc some of the model's other pr<..-tli<..1ions.  Some empirical evidence on the steady-state properties of the model Ont: of the key stend},-st:lte o r lo n~-nln ft:allires o f this model is that any permanent inere.::I."C in the proportion o f final output all<x:att;.,<1 to ddt:'nse must he offset by an <..,<\ua l d<..'d ine in the propot1ion allocated to prh":ttl' e()nsll m pt ion . ~ The n.:ason for this fe:HlIre.: is that the capitaloutput r..t io is determined solely by the p:II:llno.:Ier."; o f tastes :md [cchnology Ch:mgl:s in the !cvL·1 of government purchases or the sh:tre of gove.:rnillent purchases in GNP. I hl'refor<..', have.: no d'fl'l't on the capital-olltpllt r.:l1io in the long run [ havc ;dre:ldy notL--o thm all im't:stment in thc :o.tcau},-sl ale is repl:lCcment invcstl1l<..'nt. oK Thus. the shart: of stc:ldy-st:lle inve:o.tment in s\<..'acly-stalc outp ut. (Om), is also invariant to changes in the Il:vcl of defense purchases or the sh:trc of ddense in GNP. Simple arithmetic, then , requires that ch:tnges in the share of defense I'<-oden l Rese rve Bank or D;o lla.\;  Table 1  Consequences of a Permanent Cut in Defense Purchases Effect on:  ClI! Purchases of Final Output  Cui Manpower  Increase Increase Decmase Decrease  Increase Increase Increase Increase  Increase No change  Decrease No change  Decrease No change  Increase No change  Consumpbon LeISure Private employment Capital stock Real wages Short-run Long-run Real interest rales Short-run Long-run  purch:l:-.e" he fully n.:lll'tll.:d in ('ha n g~'" in 111\' of con "lIl11plion purdl:I""'" '' T Ill' fOR'going ('ondu"lon b :-.('n.,ilh\· 10 ItO\\  ,,11;11'<':  th ..: gO\''''rnl11elll i, >i"\It\1l.:d 10 1111:111('\' II, (\d ':I1:-.\· ~) far. I 11 ,1\\' ;1,:-'UIlll'd Ihal lh,,: ,\.:0\\'1'11lll\'n! C:.I1l fin:lIlo..' :111 pmdu,\:, of goo(\:-. al1d "4;'1'-  pureh;!",.:, \it'\"  h~  Illmr-,ul11 I.1X:UIOIl. 110\\ ('\ \T \\I1l'11  PlIR:h;I-"':" IIIl1.,1 ht: tlll:lIlt·,,'<.1 h~ dNonl<'Il.I~ [:1:\""':-'.  poilll (k'dint: in till' .. h:lf\' of con,ump tio n in G NP. Fi~lI l\: - pl'l..·.....'lll.' .'>( )III": c"lIal e:nUC!K(' of a 1lt:~:lII\\' rd:ll!ol1,l up 1)I.'1\\'\'\:n l Ilt' "hares o f con"lIIl1pllOn .md (1...-f(·n"",-' PUfl'll:l......::-. o\er lime:. Hen:. I ] lhll I h\· !ll(I\"'llK·I1t..  hllmh .....d  )\.:1 ......  in I h ..:.....·I\\O \. lIi ahk:-. (l\('r o n e  from 1&-''910 1%'9 11 'Ille: tlgllrt: a lso  IIldu(k:, .1 ' lIl).!k rt..·gf\·:-..~ion lin", for rl;;'fe~nce: As  change: in th\' .,1'1:11'\' 01 '[\,,:Id~ -,I.IlL' o UlpuI ah'o()rho'd hy the: j.:o\,,'mnll'1l1 \\illl1t1Iollgt:r k :I\,,' l lk' :-.1i;1n: ;llk"':al,,"'(I 1(1 pm " I..: imt:,IIllt:1l1 lllKh:'llgt:d. 11K' n:I.lllon:-.hip Ix·I\\\.....·n Ih\· ,,11:lr\' of Con'll ll1plion ,lilt! ,hI,.' ,· of <..!...-k11',\· pll f Ch :I .....·' i., lIO\\  pr\'dict\'d h ) l ilt' theor.... Olill in,,-<1 in tht;' pn:\iOll:-. .....'(1ion. t]K·' ..... 1:> :1 neg:""\' reblion:-.hip IX'tween Iht;' 'h.m.: of ddl·ll.....: pllr\' h ,I"""~ in G'\P :Ind [he sll;lrt.' of pmal\' n)lblLrl1pI IOn plln:h;l~"' . \X·hi!...- [Ilt:' o]).-...:r'\":\Ilon:-. .1''o(lu.llL''d \\ il h Ihl;;' w:lr year.. 19-12-r ; :-.t:cm 10 I'll.' ()tll li('I-" :111<1 P:1l1iclll:trly intlul!/lIial. Ihe finding of :1 1lL'~:III\'\' I'd;ll;on:-.hip i, foh ll:-.t to Iho.: omL...:.ion o f  ,6)  [11,,· .....• ()h:-l· I'\':I1I()Il~.  ;I  9 -( I-OI,) ( I- e'~1 ).  w lle re 9, i" Ih(' ..,han.: o t l't Hl,Ulllpl ion In (;'\J I' . .u i:-. IIlI.' (';lpil:\I-(lut pUl 1~ll i () in I ll ...· ah."",·nc\· of <li:-.1011 io l1 'lI), lax;llion. :lr1d i ., 111(' .. 11,11'1.: o f (1...-r...·n:-.\·I>lIfdl:l'e:-. in G'il' ,,, TI K' h ll rtkn (,I innclst.:d tldi.:n.,t.: pur('I1;I"I.'., in 11K' .,I(':t<ly ..,U lt: i, hOl1w p:l nly hy to\\\'r ('(llhlllllpIIOI1 ~lI1 d p:1(11)' hy lo\\'('i' in\'(',"I!l1":lll IIKn:a."".'(1 ddl·n .....· ptln.:h:I'\·' 11('(:<-,,,,il;I"'-' highcr <li:-.lol1 lon.(1)' !;IXt:,. w h idl in lllfil l(lwt:r Ill ...· r('[lInl to ;0\ c~tllWnl (11K' P()'I-I'IX In:lrgill:ll pr! ){luCl ()t C:IPIl;II ) ;Int! l1lU~ 1(J\\t:r lilt: :-''''-·:ld}--.1,lll' clpit:1 1  Fu rl h""r .... \ Itk-nn' on I ho.: n.:btionsh ip Ix:[\\'('('11 IIII.' 1\\ (, ,11:1 1''':.'' b ).:;\'(.'n by Iht' follow ing  e,•.,  'I(x'k o.lI11I1)OI11\· u:-l'd l',\II11;I1(" of l it(' P:I1:1I11l'1\"-"  Ih:11 t!,,'K'l1nil1\' JI ;Irl' p - 0.01. ~ - 0.1. ,lIld O~ = O_:H Thh ghc, II-. ( I -OJl) - 0 .- . .'>(1:1 I lx.-n,:\·rl1:1gt:  pOUlI 1110\::1 .....• III Ih\· :-.h;II'\· of <kkn .....· purch;I .....·., in  G,P \\(lldd  Gill""':  .11\\(Hhird, ()1 t · rx·I'\.·L·IlI;1g\·-  Ecullomic Kt" 'lcw _ J :UIU3I)' 199 1  Illa/xx supply 15 ,nelas/lc. changes In /ne level of defense (JUICi!MeS ll,eoffsCI Oycl!angos In rheklvel  01 consumpt/Oll  (JUIctl<lSCS  OllteoainatlOtlal-dCCOUt1l5 est.males 81enof avatlable forme ye.ffS belrxe 1929 ~or /116 8afUer peflOO_ I used /I!e CSIJ-  ma'es 01 GNP. consump/1(II'l 8r>d OeIense speodll'lg JI'J 1I.f!'f1(1f,eJ< ( 196IJ ApperId'T A Ker>drlCks eS!.Ifr,ales were conS/,ueIOO on a s;mtIat oaSIS /0 /hose oIlhe Conwne<-ce DeoiIr/mefll and can De con5lderoo comparable /0 /he o(IO<:,.li seres H  Figure 7  Cross Plot of the Share of Private Consumption in GNP and the Share of Defense Purchases in GNP Shala 01 pnvata  con~mplion  In GNP  85 80  i  75  ..  70 65  ..  60 55  50  '5!O--~05'--"~O--"'5--"OOC--'~5,--o'Oo--"<5-'~'"OC-~'5 Shale 0' Cle'ens a purc!1ases in GNP  log(O, /  (1 -0  J) -  O.ot • + o692"1<'!-.>(0" ,10 -0"  I})  (0036) (0.079) - 0.1-;2'log( ~"1"/( 1.fJ""f'»  «>.027) + 0 OH4" lo~'( O'kf'  / 0-8,,,,,,.,»  (0031)  RJ- 088  D\V-I.9')  SF:: - 0. 11 6  F - 2 IS';7.  The stand;u"d I.!rrors of thl.! cOI.:fficient eSlimatt_'s an.:  " I applied 1/10 Io9'SIIC IronsformoltOn Iog,x I( 1 x )) 10 Ille dopcndcm and IMGependem veflables 10 ensure 11181 Ihe model was da la·a dmlSSlble /sec Hendry and RIChard. 1982 and tOO3} " We can also eSlllTl810 the follow>ng comlogra/mg regres$IOfI  100(& ,1(1  {I .))~0059  02191og(O.... ,I( I~""  ))  The  siandard srrOl 01 the eslmated coeff/Clef1t 01 lhe IransIDtmea Share of dc/oftSC purch.Jses j$ 0 0 12 The Dur/>ln Watson StBI'StlC Itar! Iht$ rcgrCS$lOll IS 0 66 ThIs exceeds the 5-pcrccn/ cnlQ value Itar! Eng/B at>d Granger ( 1987} SOWCCanffl/flCl th6 nu1/oinocolnlcgra llOll betwoon the IWQ  1'3I..abies WilareaJSOaDIe tofClCCI thefllJlolno~1J()fl when we Catry out Dckcy-Fu/Iet IIfId AuQmenroo DockerFuller leslS Of! me res.dtJats har! the COIfI/ograrong fogres~  in parl'nlhl'scs This equation was l'stim:III.."<.1 hy ordinary l~a"'l square.., u.~lt1!-: :mr1lI:11 d:lt a for {he Iknod 1889-1979. with thl' oh"",,'r.·:ltiom. from 1l)KQ.-H9 ret ainl'd to ~\':J ll1~ltl' th ..• out -of-sam plc fOn.'cl ... tin!-: p~rformance o f thl' mode! I! By ~l:inda rd statbli(.';11{." rtteria. the modd illS thl' (!;tt:1 well All tbl' (."odTkil'nt l'~ti1llales :1n: ~ignific:lnt at tbe oj-percent k\'d Tlll'rl' i .. no l'\·idcIKe of .~l'rial cOrr\:blio n or hc tcro... kl.!dasticity in th.: r~~idl1 :l ls Tc.. t~ for omiHl.!d \':lri:lhlcs :1nd Illi... ~p~l"ilkation o f functional form fl1nhcr sl1ppon lhl' mo(ld. T:thk 2 ~l1l11m;lrize~ thl''''l' al)d other Tl'... I.~ of modd<.·ifkat ion. Thl' \\ iThin -.~:lInplc lr:l ..·ku1g f>l:rfo1"11"1;1I1<:C of thl· 1l1udd I" quill' good, as i.. its oUI-of-s;lInpiL' forecasTi ng ahility. [ cannot n.'jl'CI the thai tlll.:re is no hias in the out -of-:.;:unple forcc;lsts of the mudd during Ihe 19HOs On the basi:> of Ih l'.~c findin!-: .. , [ (an he (onfi{.il'nt {il;ll the modd provid...-s a SO\,IO(\ hasis for predicting the long-run ...-ffl'(."\:o. of:l pcrm:tnenl nll in Ihe .~ hare of dcfen.w pllrd1a ... e.~ in GN P on Ihe :-.harl' o f consumpt ion pU fc l1ast.'.. in GNP On.: is:o.ue thai :o.hould lx' addrl'.~:o.ed l"lCfore pnKccding b \\ hether the st:llion;lrity assumption, thai undl'rlic the a'YlJlploti<: tho.:ory u:-.~d for dr.l\\"ing inference!> :tbo ut the n~dlil"il'nt e:o.lim:HCS in the mudd are ~lI isfiL-·d . Te:-.ts for lInit roots in Ix)th lo~o{ O,/( 1-8, ) and log( 0"1/( 1-8,'/ » sllggest Ihat Ix)(h the:o.e vari:Lbles arc norhtation:lry. Ho\\'ever, il L:. possihle to writL' al! th~ p;I r.ltn~(~rs of inl~rc:o;t a~ coefficients on 1Ll~:In ZL'nJ. nonintcW-:,u<,-'d reHressors 'Jllcn:fore , (hL' results of Sims, Stoek, and \X' :lI!';Of) (1 990), n:l1ndy thai sueh par.ll11l'll'r:o; h:l\"C norm;11 :1.~ylllpt()tiL" di... lriiluli()r1s, arl' applic:lblt.: in this ca~~. Thl' solved stalic lon!-:-nm L'quation asso{:ialed wilh Ihis 1l1odd is log( 0, I( I -0,  » - 0.044 -  0 22 I °lo!-:( O,~., I( l -O,kj » (0. II;) (O.OjO).  Again, IhL' ~wnda1"d errors ;m:: in p;m:ntl1l'scs This 1.."<llLation ~hows thc rd:nio n~hip lx:t\\"l't'n the .. hart' of eon"ulllp'ion in GNP and tilt, share of defense pur<:ha:-.cs in GNP wben the share of dd~n""," pUf("ha~s b conSlant and Iht.' r~gn.'S."I()n ~m)rs take on their ~Xpct.11..-d V;Jll1c of Zl.!fO. A W:t1d tl':o.1 of (he null hypothesi:-. lhat ;ll1lhe long-n11l l1)(.'tlkienls art' Zl'n) yidd.. X~( 2)- 72.178, whit." h t.'n;thlL's us 10 n:jc<..1 tht: null at .'\t;tnd:trd signifkarn:e k'\·ds. 1< FL-dcn l  RL~ "'·<!'  Bank o f Dallas  Table 2  Diagnostic Tests Test lor Sanal correlallon First-order Flrst- 10 Slxth-order Heteroskedasllclty ARCH First-order First- to sixth-order Parameter constancy Over 1980-89 Omlned variables Functional torm Normality NOTE: All estImation and tesllOg was carried In Hendry (\989)  Statistic  Pr(F>I)  F(1.85)... 15 F(6.80)_.35 F(6.79).. 1.46  .7027 .9074  F(1.84).d9 F(6,74) ... 30  .6679  F(10.86)=.11 F(I,85)=I.801 F{9,76) .. 1.218 X2(2)m56.305  .9997 .1832 .2968  2013  .9364  out uSing PC ·GtvE. The tests are tully documenled  Thi~ l"<llt;ltion PHI\ldl·,.1 h;"I'" fill' cllnil:lIill).( \111.: hlll).(-I":rIll d"kl·I'" (lI1 till' ~h. l r<.· "f pri\;!!<.· UI11"'WHP!I(1Il jluRlu ... l· ... 11\ (,'\1' (,1';1 p..:nn:lllt:nt <.h.lng<.· 111 th..: ... h.ll"l" of ddt'n"'l' pun; h.I"l· ... in (~'I' TIll' lIlodd ~lIl-*t·~I ... Ih.1I .1 n:dlll"tion III thl" ..,h:tn: 01 dd..·n ....... from 6 I"x.'rn·nt 10 .~ Pl"i"ll"11I or (; '\ I' \\ oltlt! l'\ l'ntlt;llI~ .Idtl ;Ihmll 5 1">1.:1'<.<.'111;1;":<,' poin .... 10 till" PHlpollion 01 ( j ' l ' .,IIOl":lll'd to pri\ ;l1l' nm",ulnplil)n PUrt l l;I"l"  Defense spending ~nd economic growth  In pr:Il'li ......·. 11I)\\l·\l'r. 11l;1I1y an:, l~-'b hdit'H' ciUI the k\d of (k-fl'n~l' pllrch a:-t:.., h;h IlnplicaIlorb for ;111 l'lOll{lm~ ~ ;":1'0\\ th r:1I ..· III Ih ..· lung run. Ikll'n"'l' purl"li;t"l':-' 111Ighl .rfi":lI ).:ro\\·th through "'l'\ l'r:d dLlIllll'l ... FIr-I. dd.....·rbl· p u rch;"..-::.1,.....· om' nHnpor1\..·nl 01 Ihl' gl:lnd 101:11 of P:O\·t'fllm ....·nt t:'\pt.·ndrlUlL· ... Ih;1\ IIllN Ix' tlnanl'\X1 hy r;11..,11lj.! 1.1\ n..·\o.:lll1l· T h ..: ,y,t..:111 ofl.l:x..: .. th;lI ha:Ill·<.·rl {·olhlnlclo.:d 10 Ihl~ l'lId (" ..Iort:-. th ..: incl'llli\ l· ... 01 mdi\ idu:d hou .....:hokb :111<1 fi rm~ 10 ..;1\<.' ;lnd lI1\e~1. nOI ;11\\:1\':-' 1{11" 1)1\..· 1"11.'' '1 A CUI in dl·k n-.l' pllrdl:l:-'l·.~ Ih;ll ,.. o ... o.:d 10 fi n:Hll"t::' :1 Ull i n  inl"I"I':;\:--"'~ 111 til .... )..:!"()\\tll 1~ l l ..·  1.I~l·:-' (1 Ill':l]lltal innll1 l<.· ( II \'a ri(lll ~ ki nds \\"ould :-l imu l:i ll' in\·l·...,II11t:11! ;uld ":<'·( )I\ (lillic grow th I ,  'tl·ady-....lal<.· l'{luilihriwll \\ou ld IX' onl' in "hich l"on,ulllption. oUl pUt. .lIld Ill..: L l pu.!1 ..,to(:k wen.'  :--l·{"Olld. high IL-\·I.:b (If m il itary rl· ~..::r rl" h an d tll'\ l'IIIPllll"l1t"l1di ng d !:l i n p roductive rl'~OU1Tl"S from Ilrl" pri\:l I'-' "'l'cto r l lt: 11 o l h l 'rwi,t: wou ld h..: ..:mplfJ)'<,·d in t he d..:vdop !l1t:nl of nt:!\Y p rod u c t ~ :rm! Il ·t·llno logit.·:-. hy privale finn' Such dl"vdop m ....·nl " l":-.~<.·nli a l \0 rl'I:lin i ng ;111<1 in cr":iI ~i n ).: markl 'l .. h:lr<.· in Ih..: bl"t.: 01 international (."ollljll'l ilion. lllll". II I'" l·:-.:--..:ntial to growth O\'l.:r the long  h thl"rt.' .11l~ t"l·;J-.()Il to ..·\1"11..... ' :--lI .. t:lilll·d (JI" (ll llPlit I"nlill nih in dl'll-n'l" p lll"l"h;\ ....·...,~ Till' litl'ol"l'l ical di.~(:lI:-.~ ion alx)I(.: al):-.ll~Kl,,·d 1"1"\)111 gH )\\ l ll dfl".. I:-. alld j(ll"u:-'l·1.1 (II) th..: :)II()(:ali( In ( )f fin; 11 (llIIPII! in " Hlg -nill. .... (..::Id )-.1:lle ..:qll il ibri tl l1l It would Ix.: n.:l:u i\'l" l} ~ 11~1i;..: 1l 1 1 (l!"­ \\;1rd HI Indlld .... ).:11:1\\tll tll"1\1.:1l11y l·,\" gl·Il()lI" ledull{,;d th:lllg..: in lill' mudd. in \\ lll{"h GI-.(,· thl.:  gJ"()\\ IIlg :11 .1 l"OllllllOIl ,";"It· In 'lldl :1Il ..:\;Il·n{k-d Il'r"'lon of Iho.: h;",il.' modd. p ..:rm:IIl<.:nt l'lIl~ in d ..:fell"l· puKh:I"l·... \\uuld k·:td 10:' ll· pt:'riod of ..,10\\ l ' r g)'(l\\ Ih :1'" 111<.' t,('()!lorny :,dIU:-II..'"t1 10 Ihl' Ilt.·\\ allol.':lllon of {I111pUt. hul in Ih ....· long nm l hl' gro\\'l h ral ....· \\ollkl f<.·llInl 10 11 ... ori).:in;11 k·\'<.:1. Econ o m ic Rc \·ic ..... - Ja nuarr 199 1  For e(amp/e L ucas (1m} liaS e5llf"tUled Ina! efImNI;;jllfl!}  caprill  J()COfrIe  I.1UIIOrl -...ovId  srocJo. by 35 percent  tlcreaS8 /he US captar  rtlll , A n  il  in milit:ny fl'scarch and development  Lindau (1983) find a neg:.nive effect. In Barro  ( R& D ) thaI frees S(::'lrce H&D resourt'es for priv3te-  (J 9f\9a). government spending is decomposed  scctor use will stinllli:ue the lInderlyin~ rate of economic growt h,'~ Finall y, mi litary spending crowds out other more productive fonns of government spending, such as investment in (."(./uL"ation and infr.lstrtlcture As David As(:hauer (1 989) rL-"Cemly noted. the quality :.tnd quamity of the public Glpi!:11 stock in pan detennines the rate of return on many pri\,ate investment projects. The delerior.nion in the stock of puhlic capital over the past twenty yelr:. is well-documented ;lnd contrihuted to the productivity s lowdown that occurred over the s:lme period. The importance of education and hu m;1O c;l pilal accumulation in economic growt h is ;llso wdl-known a nd may be the single most important dctcrm in;lnt of growth over long periods. What is tht, (:viclence o n till.' relationship ht:twecn military cxpcnditure and economic growth? Empirical studies of the rd:Hionship hctween milita ry spending and economic growth fall into two bl'<Xld categories. Fi r~t , some studi("s focus explicitly on this relationship and ignore how other components o f government spending may influence growth. One paper in this category is Faini. Annez. and Ta ylor ( 1984). They find that military spending has a dear negativt: efft:ct on the growth rate, 'nleir results arc stron~e:-t for Jt.'ss-developed countries. hut they arc unable to find any significant relationship for the dc\'eloped countries, The second category of papt:rs focuses on the relationship hetween govcrnmt:nt (:onsum ption purchases, broadly defined, and economk growth , Included in Ihis category ;Ire the p;lpt:rs by Kormel1di and Mcguire 09H5), Grier and Tullock ( 1989), Ibm (1 986), :lnd I,llndau (19R3) , Thcse pap<:r,~ reach conmcting conclusions concernin~ the inflllenL'C of government purchasc,~ on economic growth. Ham (l9R6) finds a positivI.' effect. Konnendi and Meguire (1985) find no effect, and Grier and Tullock (1989) and  inlo consumption ...,pending. infr.Lslmctural investment, spending on edUGllion, military spending. and spending on MXial progr.llns. Barro is unable to find any relations hip lX'tween the share of defe nw spt:nding in gros.~ domestic proouct (GOP) and the growth mle o f GOP. In view of the conflicting find ings of thest.' :-rudies. it is undear whether the United Sta tes can expecl any sust:lined increase in the growth r:ate of o utput as a H.'sult of penn:tnent reductions in ils defense btldgt:t. FlirthenllOre, the ambiguity of thc evidencc indicates that my modeling str::ncgy of exdlldin~ a rebtionsbip l.>etween defense purchases and Olllput growth is appropriate as a first ltppro ximation 10 realit y,  .. cne somcllfflCS heats lhe oppos.I6 argw"l6l'll mal rm,'ary  rescarch and developmenl has vsIuiJbI6 sprn-off effecls for me ptrvallJ soctor II SIJCf11S plawible fhal fhese beIlefilS <Py PBft/y oHset ~ costs 01 8 /arDfI mtillary research eslab/lsllmclll  Conclusion I have argued th:1I the principal gain that will accompany a pcnnanent rl.'duction in defense purchases will hc an increase in private consumption that will m:lkc the :lverage household better ofT in the lon~ rttn. I quanlified the effects of:J. rt'duction in the (,kfens<: budgt:t on Ihe share of consumption in GN P and showt.-'d that a halving of defense purchase..., in the foml of a reduction from 6 percent (03 pcr(."Cnt o f GNP could be expected to incrC:lst.' the s hare of pri\':tle con:<.umption in GN P hy .3 percentage points in the long ntn It is ltnlikely that there will he s uslained changes in real interest rates. It is :dso unlikely that there will l~ any sustained change in the t:conomy's r.ltc of j.!;I'owth. My an:!lysis abstracts from the short-term adjustme nt costs th:H some hOllse holds a nd fimls will he:Lr as dden .~c spending is Cll!. hut in the absence of nl:ljor stnLctura l rigidities il is unlikely that these costs will persist. Finns that produce exclusively for the milit:try will cxrx:ric nce difficultie~, and somt: of them will go oul of business. But as these firms dose. they will free sca rce rL'SOurces of C:lpital ;l nd labor that will eventually he e mployed in other sectors producing consumptio n goods. The COSts incurred during the process of re:IIl(X'ating these resourccs will , in any GI<;C, be o ffset hy the g:lin th;1I lower defense spending wi ll eventually c reate for most household:- and firms Federal RC"5c: rvc Bank of [);alias  Appendix As I have already noted, the steady-state capital stock is determined by the condition that the net marginal product of capital equals the pure rate of time preference, r~(KJ\' ) -  0 = p.  Rearranging terms and premultiplying both sides by the capital-output ratio gives us F~(K , N)K_e _ (  -  y  ~ -  p+u"-, . }'  Under the assumption of constant returns to scale, the steady-state capital-output ratio is given by K  (J~  )  p+o  -=-- ~j1.  ,  )'  p+o  K  -=  0 - ·r)0~ =( I - r)j1, p+ Ii  where r is the steady-state tax rate. If the government is required to balance its budget each period and has no debt outstanding ini· tially. its budget constraint is G,'Ir1 =t , l ~  where O~ is the share of capital income in total steady·state income. Because all investment in the steady-state equilibrium is replacement investment, the share of investment in steadystate output is  o = 0/\ = o8~  government. This suggests that in a regression of the share of private consumption purchases in GNP on the share of defense purchases in GNP the coefficient should be -1 . What if, instead of financing its purchases by nondistortionary lump-sum taxation. the government must rely on a distortionary tax on total (gross) income? In that case, the steadystate capital-output ratio would be  =0  J1 .  By definition,  which in the steady state simplifies to r '"' 8".,. Even if the government has the ability to issue debt to finance spendIng , the relevant budget constraint requires that in the long run the average tax rate equal the share of spending in final output. Rearranging the adding·up condition on expenditure shares, we have  8.- 1 - 8-8 . "~~ Substitution for ~ in this equation using the above gives us  where 0eis the share of consumption in steadystate output, 01is the share of investment in steady·state output, and 0cIM is the share of defense purchases of final output in steadystate output. Because 0, is invariant with respect to changes in O".t' the share of steady-state output allocated to private consumption must fully reflect changes in the share of steady-state output absorbed by the  Ic(;o nom k Kl·.·kw - Jan .. :u·), 19') 1  9. - 1 -  (l - t) OIl-9,kf'  which can be further simplified as  9, - (1-0 "I" ) (1- 9"I )' which is equation 6 in the text.  .,  References Aschauer, David Alan ( 1989), -Docs Puhlic Capil:!l Crowd Out Private Capital?- jO//I1/£/1 of ,I folletary' Ec()//omics 24: I 71--HH.  - - -, and - - - 09R2), -On Ih...· FOnlluiarion of EmpiriGl 1 Models in Dynamic Econometrics,- JOUrI/(/1 of &01101l1('/rl("$ 20: 3-33.  llarro. Robert) 09H9a). -A Cros...;-Counlry Study of Growth, S:lving and Gon:rnrnent.- NBER Working P:lper No. 2855, Fehn1:lry  Kendrick. John \VI. (196 1). PlVtiliClil 'ity Trellds ill the UI/it('d SI(//('s (Princeton : Prinn:ton University Pres:.).  - - - (1989h). -The NeocJas~iGII Arrro:Kh to Fisc.J1 Poli(';y." in Modem Busilless Cycle 71)(.'Qry. etl R.J BarTO (C.1mhridge: l l:lrvard University I)rc...;s).  Konnendi. Rog .... r C. :lIld Philip Mcguire (1985), -Macl"OCl'oll()1llic Determin:lots of Growth: Cross-Country Evidence," ./olmlll/ ofMO ll ettlr), ECOlIomlCS 16: 141-63.  - - - (1987), /H(lcroecQ ll olll ics 2d c.;d. (New York: Joh n Wi le.;y and Sons).  1";lOdau . Da nid (19~3), "GOVl:mment Expcnditurl.! and Economic Growth: A Cross-Cou ntry St udy," SO/I(ben t /;"cOltO m icjOllrl/a/ 49: 783-  Engle.;, nobcrt F.. and ClivI.! W Granger (1987), ··Coinlegr:.lliol1 ;Ind Error Corrn·tion: Hep re.'il.!ntalion, E<;t1mation. and Tc.;sting. ~ Ecollometriat 55: 251-76 Faini. Riccardo. P:llril"ia Annez, and i";lncl.! T aylor (19&1). - J)dcnse Spt~nding, El.:orlomi<..· Stnll.:ture. and Growth : Evidence Among COllnlries and Over Timc.;. - 1;(;Ollomic I)('lv..-!opmellt (lnd ClIltural Chall~e 32: 487-9R  92. LUGls. Roben E.. Jr ( 1989), -Sup ply-Side Econom· ics: An Analytkal Review: m i1111.!0, University of ChiGlgo Ram. Rati (19H6). -Government Size :md Economic Growth: A New Framc.;work and Some Evidence from Cross-Section and Time-Series Data, - Americ(/II ECOliomic Rel 'ieIll76: 191-  203. Grier. Kevin B.. and Gordon Tu l lcKk (1989). -An Empirical Analysis of Cross-Nation;1 1 Eco· nomic Growth, 1951-80," jOllmal (1Molletar), I:(;ollomics 24: 259-76.  Sims. Christopher A. , Junes II. Stock. and Ma rk \VI. \VI,l\son (19')()). "' Infen.:nl·c in Linear Time St.:ric~ Models with $oml.! Unit Hoots.-  ECOllometri(.·(l SH: 113--14. H endry, David F. (l9H9). PC-GI V£: A I/ Interactive &Ollomerric MrxlellillS SYS/(!III. (Oxford : I nstirute of El.:onornil.:S and Stati.~t i cs, Un iversity of Oxford l. - - - . and Jean-Francois Richard (1983), '"The Econometric Analysis of Economic Time Series, ~ I lIfematiollal Statistical Review 51: 111-63  ••  u.s  Dep,u1ment of Commerce: Bureau of Economic Analysis (1990), StllwyofCu rrellt J3l1silless (Washington, D.C.: Government Prin ting Office, Ju ly) .  Wyn ne, Mark A. (1 989), tbe " l:]Rn'P,tlre Effecls of Temporary Govemmelll Pu rcbases, Ph D. dissertation. University of Roches!er.  Linda C, Hunter' Visiting Assistant Professor San Diego State University  Europe 1992: An Overview  T\)  O\'t:'I"COlllL' tht.: L'C0I1011lil' :-;tagnation and unt:'lllpioymL't11 that l'ha'~tl'lt.:rized I ht.: t.::tdy 19HO:-.. tht.: EUfopI:an C01l1111l1 1lit)' (EC) ba:-. CI11harkL'd on a lIn ilk;l[ion progl~llll, In 198~ " .r;ll'qllL"~ Delon', p l"t.:,~ilklll oj tht.: Europt.:;lll Cotnmi:-;sion. ;u1d his fL' l!o\\, l'()1ll1lli:-..~i(l I)t.:r:-; prt.:,,,"'ntl'd :1 propos:llto i[wi,l.!ol'att.: t11l: Eu ropea n t.:conomy. This /I'hile Ix/INr cl l kd f( II' till' eli m ina[ion of inll'rn;l l Ir..lde h arril'T:-- hy the end of 1992, Tilled "Compkting tht.· Inh,.. rn;tI ,\l:i rkl'1. - Ihl' while papt;:r :-;c\:-fonh ap pro-.:imat ..... ly jOO din,'l"tin.'" to :tchic\'" :1 unifil'd Europt:an Illarkl,:t Tlw liter.l!url' rdl'r:-; 10 tlli:-- progr..lI11 ;1:' 1:'/IIlJ/li' 1992. Although thl: EC-\\ hidl l'on:.i:-ts of l:k:lgiulll. Brit:lin, i1t:lllllark. Fl~ lIlt"l'. GfL"t.""(.·t:, Ireland. Italy. blxt'm hour,g. 1\l·tht.:rI:lnd.... I'()nllgal, Spain. ;lnd \Ve:-.I Gelln:II1)'! -i.. n,:fL'ITL'ii to :I,,, a CO/1IIm)11 //I(//"kel, this tt:'l111 i... a Illi""o!ller \'(Iii hi., a common 1ll;lrkel. thl'l\.' :u\.' no h l rriL'I':'o 10 the mon'menl of g(xxis or f:t(1ors of prot.lul1ion. F,vl'n though al! fonnall;trifl:" :Illd quo!;l:. in 11~lt.1c h;l\'t: Ix."t:n diminatt:'d \"\"ilhil1 thl' EC. l"q.:ubtory imp(_-'diment.~ still ()I)stn.IL'1 Iht: Il()\\ ()f W)()( I.~ and factors of pn )(I1I(,:tion Acc(::pt:mcL' o f thl' whi[e papL'1' p rop<.JS;!I:-; \\' il! ensure tll<:.· {"Olllpll.'[l' mohility of goods :lnd f:tcl\)r"~ of production. If thi~ o.:t'urs, then the knn COII/IIIOIi II/wi.'el willl>t: more ;Ippmpriate for 11ll' EC T h is artick l'X;II11i nl..·s till' whilt' p:l)X'f pro]'>o:-al-> and l ht: dfL'Ch of the diminalion of fl'gublo ry b:l rri c.:r.. on EurolW In an effort 10 prl':-;:-' for :Kccpt:\lKl' of Illl' l'nlin,.' unifk:l1ion progr.un. the European C01\)mi ..... ion ha:. not St.'! prioritiL's on 11K' w h ile paper propo...:L1:. limn'H·r. four key 1\)l':I.. ure:-- \yill nll1tnhutl' tn th..: ohji:.'cl i\·e of:1 u nifil'(l Europt;: Th t':'>\:: n1l'a:--un:s :lrl' the dimin:uion o f I)()rder CllIlm l h . (1)X'ni n).: of public pn IClI n:::.'llll'nt , h:lrmoniz;ui()1l ()f tL.'(·h ni(';11 .~ l a nd:1rds and rq~ ub Eco nom ic Rcview-Janu;lry 199 1  lilms, :l nd lilx:r:t liz:ui()J1 o f c:l p it:l l movcmcnts and rcl:ltt:d fi na ncb l :-;cf\'k e:-- Rellloval of these restrictio n:-. 10 inlra-EC lr;l(k will dimin:I1(' ll1:my d iSTOrtio n ... in thl.: Europt.:an lll:lt'kclpl:ll '(' AltllOUgh e:-.lilll:l lt:," v:l ry C(lIlsiderably, EIImlX"s g:lin .. from h":coill in).,: a unified market ;I fe potel1ti:L1ly brgl.'. Not on ly will illllllt.'ilialt: COS[,~:I\'in!-( ht:nt:nt~ n:Mllt from thl' rl'moval of rcgulatory impt;:dimcnt:>. hllt ;l1so IOll).:l'r-Ierlll gain .. w ill rL',.. ult frolll incrc;lsl'd ('OIl1pctition :111(\ finns' cxploil:llion of SCilk' c~'(jnollli..::-. Eu ropt:'s gai n:> will not he l'venly dbtrihutl·d :uuo ng mem ber countrio.:::>. however Mo:-.t ,..tudil'" :-u~e:-t [h:1I lInific.l ti(m \\il llx:nefit countrics ()Il tht.: pl'riphery-sllch as 1'0I111~:11. Spa in, and Cf\.'L.'(·I..- -les..., th;1I1 those in the intt'rior of Europe, :-'Udl :I~ Wt::>1 Ge rm~my. Analy:-.!.'> h:I\'c expfe.~"l'd conn.'rn Ih:1I these ollllying ('ountries wil! lx:co!\)1..' di:-.couraged and delay I h..: proct:.'ss of lInificalion  Proposed elimination of regulatory harriers MOSI tariffs and q ll:lI1til:lIive restrictions within till' EC !ta\'e heen L'liminaK'(1 sineI.:' its fomlalion in 1')<;7, h l1tthe Community 11lelll bcrs continue to o!Wr:tlt: as il)(iividw tl cOlliltril.'s with thl.:ir own I:tws and rt:).:lI1ations OmsL'qlIL·l1 tl y. m:l ny b'lTriers to  I would li~fllO rnarJI Slew Brown_ BINGruben, Kenll-6/!. ana MIfIf! Yuccl (Of helpful corn7ltI'f1lS  LIIIda C f/\XI/Cf  J$ 8  letmet ecOIIOfTIJ$/ al IJ>e Federal  Reserve Bank 01 Dallas The daiS lor this 8f11Cie relet 10 West Germany belete UflJIlCs/1OfI WIth East Germany  tmde still exist "111e white p:lper contains approximately 300 proposals to elilUinate thesc remaining barriers. Michael Calingaert (1988) has organized the white paper proposals into eight he:ldings.-' Border controls. Border controls are clearly the most visible remaining barriers. Even though customs duties arc no longer collected at national frontiers , border controls remain because regulations and laws differ across member coun· tries. Bordl:r controls ensure that :lppropriate taxes, wh ich still V:lry greatly among Ee-member nations, are paid to the member countries Uorder authorities also enforce health standards on plant and animal products and adjust prices in accordance with the Common Agricultural Policy. According to;l recent stuvey, businesses consider delays ;l\ the border to be the most obstnLctive barriers they face. ~ AlthOllgh consumers and travelers also bear the costs of delays at the border in the fonn of higher prices and inconvenience, delays appear to be a gre:ner burden to companies. Estimates place the cost of delays at borders at almost SlO billion annually.S '111(.' white paper's most Significant proposal for removing border controls is the introduction of the Single Administrative Document. EC-member nations enacted this me:lSUfe in January 1988. This document consolidates the many (arms member governments have required at their borders. The Single Administrative Document scrves as an ex· port declaration, tmnsit document, and import entty statement. The white paper also proposes the elimination of road haulage permits and quotas tbat remain between certain member countries. Movement of people. In general, individua ls have complete freedom to move from o ne member country to anothe r fo r work, but academic degrees and professiona l q ua lific:ltions :lre  ~  FOt a detaJJed SUImI8t')' dille wtllle paper proposals. see  CaINlQB8fI (1968. 20-21. 38 (4) • Cecc,.,...(f968. 8)  • Cooper (1989. 334)  "  not unifomlly recognized across countries. Before the whitt: paper \Vas written , EC-membcr countries negotiated to recognize certain degrees on a professiun-by-profession basis The whitt:' paper proposes a gt:neral framework for mutual recognition of aU O:."'gI"CCS and diplomas in all professions. Legal differences. Each EC-memocr nation has its own national laws, and this has served as a major impediment to trade within the EC. As a r(.-"Sult, the processes of (onning joint ventures. establishing mergers across countries, and creating o ther forms of multinational businesses are much more complicat(.'d than if the EC were an integra ted market. Intellectual propeny rights are also handled 011 a natiolllil basis; trademarks a nd patents are issued by individual countries rather than through a centr.l l EC office. While some measures have been adop1L>(! in a n etTon to haml0nize legal differences, there are no provisions for the foonmion of EC-wide corporations. -roe one exception to this was the adoption of a regulation in 1985 for European Economic Groupings. '111is regulation allows finns in different EC countries to ;oin (orces on specific projects in a manner an..logous to ;oint ventures. Little progress has heen made in the area of intelkctual property. Capital mobility. 'Ihe tenn capital mobility refers to the integration of financia l markets-the free movellK'Ot of assets across member states. According to the Treaty of Rome. the document that established the EC, all r<."'"Strictions on capital movements between member countries are to be phased out progressively TIle treaty docs allow countries 10 introduce tempoi..lry "protective measures" in the event of disturba nces in the capital market, such as weaknesses in a currency or underlying problems with econom ic pol icies. Progress in dc n.:gulating ca pital movement h:ls been mixed. While some countries allow virtually unrestricted C'..lpital movement, others high barriers. The white paper lists tbree olltcomes from improvi ng capit:ll mobility: increase the effectiveness of financial intemlediarics, mainta in monetary stahility. and improve the allocation of swings. In 1987, in its most dramatic d irective passed to date, the Commission submitted a broad package designed to eliminate all controls on capital movements. including shon-term monetary instruments. personal bank accounts, and certain types o( loans 10 Fcdc-ral Rese....·t: Bank of Dallas  Indirect taxation schemes. According to the COI11Illi-.:;ion. diffcrt:ncc~ in indirect la.Ii 11:gimes :!Cro.s." memher countrie~ an.: :Imong the 11100"t dimn llt ob:.t;tc1es 10 reaching the 1992 gO:lls. Tax:uion i:> one of Ihe fc\\' areas thai re<luires un:lll illlllU:. nlll!'t:nt amon~ member counlries Tilt: white p:lper addrt::)SCs two main fonn.. of indin.:ct taxt:s: v:t lue-addcd taxe:> and exciSt' t;IXC:>. 111e n ha:. .... ttggcsled thai memIx:rs agn:e o n minimum indirect lax r.ues. Mem· Ix:rs \\ ould then he free to :.(:t higher r.ues. if Iht:y :H'e willing to acccpt the consequencc thai gcxxJ:; will he purdu"Cd in ;I reas with lowcr tax :;chelllcs Similar concerns h;1\'(' been r:li:.ed alxlUt Withholding l axe:. o n intl.'n.:st :tnd dividends As Glrit;11 controls art: diminall!d. individuals will he frt'c to avoid taxes by rnainl:tining thcir assets in cOllnlri<,.'s with lower tax r:ltcS. The Commi.s."ion propo:-.ed a unifornl Withholding tax In carly 19H9. howcver. Brilain ;md IAlxcm bourg expres.'it.....d conccrn ahOllt haVing ;my wi thholding by the sourct.· country. As a ft.':.uit. Ihis i'lsue remains unn.:solv(:d Services, Even thOllgh the servicc sector has hecn playing :m cver-increasing role in the EUfo· pe:1ll eomomy, both i n ahsolute and relatin.: tcrm ..... it remain .... highly re~lIlated. T r.lde in finan· ci:tl ."Crvil"l"'" ha:-. Ix"Come particularly complic:th.'d dUt"" (() r.lpid 1I:,'chnological change. l3ecauSI: of d isparitit's :tmonK rcgu !:.I1ory regimes. prices for financial service .... V:lry hy a.... much as 50 [X'ro.:nt among member ("t)lllltril""s As a re:oult. the white p:qx'r flX'lI."t..,,, 1l1l1ch :Ittention o n this sector According to a rccent EC stlldy, the estima ted gain from intt'gr.u ion of financial seJVices would he $26 hi llion : The Commi.~sion has made the following w~ m:ral recom111er,d;lti ons for (he integr:nion of financial ."ervict's: dercgulmio n that would allow finan<"ial illSlitution... 10 increase the geogr:lphic sl'ope of Iheir opcr:l1 ions. hannoniz:rtio n of mem· her governments' .' tandards. mutual recognition of other memher government st:lnclard.... and control :tnd supervi~ion of tln:mcial servicc:. hy thl"" coumry in \\"l1idl the nOll i:; haSl..'{1 for all o f its EC 0per:l· tion....... induding tho.-.c in other memher l"uuntril"s. Technical regulations. The disp:.r rit)" hetwcL'n tedlllil.':.d rl""gul;uion'l and sl:lndar(b Ihrou!-lhoUl the EC is high on husi ncsst: ...· Ii.... t .... o f intr.I-EC Ir.l<.ll"" prohlem . . ~ Iore than 100,000 ditTer· ent indu:.trial :.tandard" and rcgula tions currently Economic Review - January 1991  exisl. K Thcse dilYerenccs motivate finns to pr(xJuce for a n:trrow domestic markel mlher th:tn a Eu· rope-wide market. Unkss these regulations :tnd stand:lf(l" hccomc more unified. firms will ht, unahle to exploit Ihe econom ics o f sca le they nl."t..-d to be ('orllpt:l itive in the glohal marketpbce. ·Ill<..' previous systl""m of fCjtlllations and stand:trus proved inadt.'qu:l\c. so the white paper h:t" P"'fX).'il"d a nt:w appro:.lCh. Only -essential rl."quire· mCnls~ would be established on an EC-widc level under this llppro:lCh. 'n'ICsc essential requin:menl" ("Ovcr 1110:.t regulations, including those :Iddrcs."ing health, saft!ty, and consumer ancl environmcnt pro.. II.'clion, and they go ;1 lo ng way toward unifying standards. As long as member countril""S conform to thl"se rt.'quin.:ment.'!, {hey will be free to e..t,\hli.~h additional .~tamh\rds of their own. Public procurement. Although track in the private sector has cxpllnded greatly ovt!r the past 30 yt!ars. the public sector has rt!mained very protectionist In 1987. it W;IS eSlim:ttcd that o nly :tbout 2 percent of public contr.lCts are aw:\rd~d to companics in any foreign counlfY.<} N;ttionalbl ic puhlic procurement policies have created mas."ive inefficiencies As a result . thl"" whit(' paper proposes more open procl..oUures for awarding contraas to currently excluded mar· kl"I..... The white p:lper ;1150 p ropo.'lCS :.t legal fr.ll11cwork th:1I would allow com panies leverage to a.s."Cn their righls The Comm i.s...ion has cstil11;tted Ihat the savings from o pening the public procl1 remenl m:l rkct would total S21 hillion.'" The p roposa ls suggested by (he whitc paJkr arc q llite comprehensive Dcspite this, thc Com· mission has made an effort to m:tintain the pro· gram :IS :111 insl::parable whole. If the European counlrio.:s wt::re to separate the m;my proposals into p;u1S, the Commissio n argues. the intt::grity of the progr.Ull would be weakened. Consequently. the Commissio n has no t set priorities on tht!se propos:tb Of these proposals. however. four in  CiJlmglJ8fl (1988. 25)  Ca4nga9rt (1988. 26-27' Caltngacrt (1988, 27)  "  IXlltil'ul:lf contrihute the IIIO:.t to the objccth'c of a unified Europe: dimination of bonk'r controls, opening o f puhlil.: procurement, h:lrlnoni7~'ltion of tl'chniC'.J1 stand:m ls :Ind regul;l!ion:-.. and liher.I1iZ:Ition of capit:1I 11l()\'cmcnts and rebtl'd fin:mci:11 .'oCiViccs The:.e four propos;.tls arc dis(:USSL-'lI mo:-.t often in liter.lture when measuring the gains to European llnific.:;nion.  Conceptualizing the overall gains to Europe The potential A:lins to the EC from removing the barriers listL'{1 ;11)()\'e arc derivt.--d from three lypes of cost savings: the immediate benefits from ~moval of the harriers, the mediu m-term gains from enabling firms to become Illore efficient a nd exploit cconomie.~ of s<:ale, and the dynamic ga ins from technologiGll improvements ;IS the economy expands. Stlldk:s .~uAAcst that the illl'diulll-term and dynamic g:lins afe greater than the immediall' henefit" from integration The rnt.-chanisrn thro ugh whidl integration aITecls a partic ul:lr industry is ;IS follow.~ Remov:l l of lrade impediments in the industry is a positive supply shock Di.~mant l ing intern:11 harriers reduces casts for European com panies Ir.lding w ith other EC count ries . 111e price of the commodity declines as com~tition increases and finns explnit t'COnomies of scale. Competition among IInns also increasc.~ inV('stnlent. The de<:lining price of the good sales and l'rtlploymem for that indust!)'. Thus, removal of trade impediment:. causes particular induslric., to expand At the s;.1I11e time, othcr S(,'Ctors't as resources shift into the newly liber.lli zed industries. Whether t hi.~ new pattern of pnxlud ion and tmde leads to improvement in glohal welfare delx;.'nds on whet he r unificltion leads to trade creation or trade diversion . As trade barriers arc rL'llu<:t.."'<.I among EC countries. inl ..l-EC tr.lde will increase. If thi:-. inaeased trade within Ihe EC means that cUlintries purch:lsc more R{)(xis from the mo."t efficient pnxlucers, then tr.ldl· creation will have occurred. Tr.lde diversion <x:curs when changes in ~~lIlat()ry regimes divert t"lde from mo re efficient to lesS emcient producers. TIlis phe-  nomenon may benefit EC produt..'l:rs. bUL from :1 global perspe<-ti\'e. il may gener.He a system of <lisincentives th:n ll.::duces world L'(:onomic welfare. As an example of trade di\'crsion. su ppose Ihat tilt., world's 1110 ....1 dficienl pTlxlucer o f some good is 1{)(';l\ed in the UnitL-d Stale.~ ;lnd sells its product 10 Frenl.:h huyers. Morcon:r. suppose that ;1 higher-cost pTlxlucer is located in haly. but dismantling of intr.I-EC barriers means that Ihis producer ix.-'Comcs the lowe:.t-price sdler to the French If no tr.ldl' barriers exi.'led, IXlih w ithin :IOJ outside the EC. the n the U.S. firm wou ld conlinue to be tht..' lowl'st-price producer for the French. The I.:ombinatian of high external EC tr.lde barricrs and the removal of intra-EC b3rriers. however, ma kes Ihe delivered price to the French h uycrs lowe.~ l for the Iialian product In this hypot hetic:.1 CX:II11pk:, unification leads to a dcereasc in glob:l l welfare if the loss from switching to the less efficil'nt Italian p rodll<.:er outw C'i~h~ the.: gain from removing intra-EC t"KIt: harriers. The w:.y in which European unification afTects th(,.' United Statl's :Il-.c.) depends on whether lInifil.:ation re:.ults in tr-.ldc creation or diversio n hee tbe box titled -How Will Europe 1992 AffCl1 the United Statesn Figure I .~h<)ws the effects of the dismantling of harriers on a).lgrcgatc demand and supply. II The economy hegins al an initial t..-quilibrium point A. Removal af intr.I-EC tr.lde impediments  Figure 1 The Effects of Unification on European Aggregate Demand and Supply Prices AS AS'  AD  AD Economic  au",",  " Domousch (1989. 344-45)  "  F~r:li  RC'5tI'\'e Ran k o( Da llas  How Will Europe 1992 Affect the Untted States? One of the first questions that Ameri· cans ask when considering European unifica· tion is, How will this affect us? After all , the United States has a sizeable stake in the European Community . U.S. exports of goods and services to the EC totaled $160 billion in 1989. This figure is almost 50 percent higher than trade with Canada , the largest single· country trading partner for the United States .· American firms also have a physical presence in the EC . In 1988, U.S. foreign direct invest· ment in the EC was $127 billion , about 40 percent of all U.S. foreign direct investment.2 European un ification offers both oppor· tunities and threats to U.S. industry. First, whether the United States benefits or loses depends on whether European unification leads to trade creation or trade diversion for U.S. export goods. It is generally betieved that remo ving internal European barriers will lead to some trade diversion .3 Emerson, and oth· ers ( 1988) estimate that imports from outside Europe wilt decrease between 7.9 percent and 10.3 percent. 4 For the United States, this will mean a drop in exports to Europe. If this decrease in European imports falls evenly across aU sectors , then U.S. exports should fall between 2.1 percent and 2.7 percent, because U.S. exports to Europe in 1989 were 26.4 percent of all U.S. exports .!> Another potentially detrimental effect on the United States will occur if Europe imposes greater external barriers to trade with coun· tries outside the EC. The threat of greater protection is strongest in several specific ar· eas. First is the area of public procurement. Although governments might be willing to  int'fL':I'>C:-" :.),I.::ll L' l iL' m:111d :.:-.. ,l.:O(KI-. within the EC lx:cc)1l11' dlt';IPL'1' Int'fL·:l .... cd pf(lfi ta hllit~ I:li . . e .... imL· . . tlllL·nt .\J.ij..trl·,I.:.u ...· (il-nl.l nd . . hln .... from .\]) 10 AD ' PflKJU{'\i\ll\' 11lt'f{·:I:-..l·.... :1 .... finll'. exploil I..--COllUlllll...... li\ c  of ""';lle .md 1x.'(:o01c  AAAre~;lIc .... upply .. hirt ..  mort." compeli·  from .\~ In .\~  The  open access to public procurement to neigh· boring EC countries, they may not be willing to do this with countries outside the EC, such as the United States. There may be pressure to award contracts to other European companies rather than to U.S. companies. Thus, contracts that previously woutd have been awarded to an American firm will be awarded to a company in another member country. Another area in which protection is likely to increase is health and safety standards. As the EC harmonizes individual country health and safety regulations, standards are bound to increase in some countries . The increasing standards mayor may not affect the United States . If it is the case that some goods produced in the United States face already higher domestic health and safety standards, then the increase in European standards will have no effect on the United States . In the case of goods produced according to current lower standards , however, rising standards will increase costs for U.S. firms. In sectors exhibiting scale economies, increased market concentration could cause plant closings. Communities experiencing new unemployment may invoke pressure on the Commission to increase protection. Although observers fear a "Fortress Europe, ~ no overall pattern of EC behavior toward outside coun· tries has emerged. Reduced barriers to trade within Europe will benefit U.S. firms conducting business in the EC. Costs to these U.S. firms will decline from the removal of internal barriers, just as costs to European firms will decrease. Be(Continued on the next page)  {'(.'onoln}, 1ll0\ ..•....  frol11 Iht.: ()ri~inal cquilihrium:1I  poinl i\ 10 :1 n ...·\\· t'quilibmlln :11  point IS  A~R"  gal ..· output III t ile IO'nUloll\y ..·:..p:lnd . .  0\ 1:1':,11. Europ.., h:l . . ;1 ,l.:1'l·:11 deal I!) ,!.!ain hy 1">e\.'Ollling a ullitk'd 111:II·kcl. Curn.:nl harriers 10 II~I("" in Iht' EC d i:-Iorl pricc.::-.. :llld It.·ad to ineffi-  "  How Will Europe 1992 Affect the United Slates?-Continued cause defining a product's country of origin is becoming more and more difficult, American subsidiaries in the EC will most likely receive the same treatment as European firms. U.S, firms will be able to use one country as a base and develop an EC-wide network for seiling their products, reducing both transportation and capital costs . Conflicting and overlapping regulations will no longer hamper production and trade for U.S. industries in the EC. Overall, the net effect of Europe 19920n the United States is still unclear. Much of this outcome depends on how capable U.S. firms are in taking advantage of the increased opportunities that Europe 1992 wilt offer. A recent article by Robert Lipsey (1990) suggests that large American firms are already welt established within Europe. Considerable anecdotal evidence supports this view. For example, in the car market, although Volkswagen , Fiat, Peugeot, and Renault are all strong in their domestic markets , none has the Europe-wide strength of General Motors  ci!.:IKll· .... H... m O\;l 1 (If inlr:l -FC harril·r ... IlKfl·:bt.:S th ... <.km antl for Europl.:an ).:ood ... Fi rm ... l'xpallU t h ... ir 1ll:I1·kL·1 fro1l1 ;I 'lIlgk' UIlll1lr.... 10 Ill(.' el1lin.: c()nl11llll1 i l~· . ;lilo\\ Ill).: Ihem 10 ..:xp loil economi..: ... o f sc: de Grl'alL'r ('oll1 l)1..'lllion ; ll\l o n~ EC finll ... CIll"'L·.' incre:ts..:d pn)fil:ll)ilI I Y and inVC-;\lll.: Il1. \\ hid I ino-e:l ...l ".' aggre~a k .'lIppl y.  Estimates of the o ve rall gains to  I~uropc  E.,lil1l:IIt" 01 Ih\.' L'cOn(.mil· exp:IIlSiOIl  !Il  ElIrt1l)l..' rt..'~ Lllti ng  from unifk;u io n ra ng ..· from :I ~ MlI:111 a ... 0 ,) p ..,:rn.'nt of gill"',,,, d011l(..'... [k pn Kllict (GOI') 10 :1.') largo.: :1:-. ;s) p'. . n 'l·nL NOlle of till'  or Ford, The same case holds for American computer companies , such as IBM, Digital Equipment, and Unisys.' Hewlett-Packard also has more broad-based sales worldwide and within the EC than its European competitors,1As Lipsey notes , some U.S. companies are better positioned to take advantage of the unified market than most of their European counterparts .  1  Bach (7990.60)  ~  Schal/(1989. 46)  3 Cooper (1989 331). and DornbuSCh (1989. 353)  • EmerS(l(l. and oth6rs (7968, 238 41) , Bach (199{), 48, 60)  • The ECOflO<T'IISI (/989c.  74)  • The EconorT'l$l (l989b. 57)  n]{KIc I~ l·... IIIIl:.ltn/-t lilt, dfl.:l..1,,. o f Ewn pe 199.2. howo.:ve\'. fllih um:-.ldo.:f .111 rci:twd ,-,\'\"nK " II arc p:ln;;' 1 ..'q uilillri lllll mlx 1..-l:-. t\cc(lrdnt).,:!y. de~pII '-' Ill<-' dfon Ih:.1 h:h h....en do.:\OIL'(lto q llL·:-.l ioIlS :Ibolll Iho.: i!l1IXICI of I':urope 11)1)2 . 11111\\.' or il i:-. lil.:ely to r..·.'>u l! in :K'('lII~ l! e co ncl u:-.i(Hl'" .'k:\ CI11wlv...:-.. Ihcs<.: Ill(Kld,;  olf... r illlpon:lI1t pt:r'pl'l'ti \'<':' on Ihe proce:.s of "'xp:lIl:-io n III Ill<-' \\;II.:l· o f: 1 po.. i1i\'t· r"'gubloIY ~h()cl.: to tht: m uh lllalion;L1 ......·o l1omie .~y~t l· 1\1 J\ 1ll01l),: Ihe ...ludll'" of gain ... fro1\l Eurof'X-' 199.2, tht· 1110:-.1 \\ idely (Ih•.'d \\': .... conducted fo r I Ill..' Commi:-':-'lol1 undt'r [Ill' dlrCl'lion o f ]>;1010 Ce<.Thi ni (19~) ," TilL' ClO'cchin i r<.:lxll1 t·x:lrni ne .... tho: din.:ct g:lilb of tho.: in itial ... lIp pl y-~idc .-;IIIKk from 1I1L' fCI11O\ ':L1 of h:IITit'r:- and tll(..' indi rn1g:lins from  linus L·:.:plllll:ll ioll ol "'·;111..' (.T<,·a .....d finn dficierK~ EmerS(l(l. 8tld others (1968) proVIde a dela.1ed deSCllpl>Oll aline Ce<:c/lJrII study  ('<.OI1 ()llll"'~  :Itld in-  To ..· lll;1I1O' t he d m..'(.\ gai n,. tit .., Cecchini l eporl qU:lntilles th ..· h ..: ndih fro lll dilllin;lIion of ft:de R..~ n't: Han k of na ll a!>  Table 1  Average Estimated Macroeconomic Gains from European Unification Real  Consumer  GOP  P-  Employment (in lnousands)  80fdef Controls  .4  - 1.0  200  PubliC Procuremenl  .S  -1.4  350  Financial ServICeS  15  -1.4  400  Supply-Side Eliecis  2.1  - 23  850  Tolal  4.5  -6.1  1,800  Barner  SOURCE: CecchIni (1986), Table 10 1. 98.  honk'r lonlr"h. lhffL'n.:nu.:~ ill Tt.'lhnILI I ~1:l11d:lrd ... puhlic pnllUl"l"11Wlll rl'~I1'il'li(ll1'. ;lnd rq.':llLll i(lIl~ in  ,Iudil,." " I l wir IfL·;\IIllI,.·1l1 01 im ..·..tIlK·nt ;I1UIII:- cf-  ~l']"\ ill"  ,l.:rl)\\lh  ThL'~""  h..:lIdl" ,II\.' l:dnlbtl'd ll~Hl1-( indi-  \ Klll:11 indu"I]"\ ~lUdIL'" III '>\..'\ l'n  rc l"Olllllf1l',  Tht.''L' l'''[1111;11\.·" , ...... ,.ddl,d 10l!l·lh.... r ;u:ro..-. mdu .. [r it' .. . ;1"-'llllll11.1.! Ih.1l tIll" r.:m.linlllJ.! th'l' ICC  [rie ..  1\  ill  }t;lIn III  UI\IIl-  pn'p'!llLlII' !1l [h ...·lr GDI' I l1 lh l"  'o.:"'l·. I lIl'''l' .lIl· p:lnl.ll L·qllilil)]"iLlI11"'·'lil11:l l l·.~ 11l'-  kn, on 11K' ...-:lpit:11 '10(1 \\hIlL' C..."("(·hinl l'~lill1alc'" cllLo<-\ .. h,r:1 gi\l'n L:I]1II;11 "'U)I."J... Ibldllin  l·'llIll.1ll.:'.1 11K"(itlllllil'rm J.!n)\\lh Ix.tIll'  fU'ill  Ill("  l·O·I,."(" of '>\..·;11L· l"('OI'01llIl" Oil .1 ).tro\\ ln1-( cap l!;d 'Iod.. Itlld\1 In .lrgllL" Ih.n ;1, Ilil' '-(.11L· 01 econ omic .ILin Ily iTlITI::I'<'. till" I"dUn! 10 l;ljlll,1 1 1"1'>\..". Cft:::llin g  ,I )..:TealL'f inn:ntl\\.· for IIH l ·, lnK-IlI ()\11Plil II ill ri~  C:IU"l' Ihl" Cl'nllllll fL'J)( In dOl."' Ilol ('(ll1~](iL'r  "1-(,lin. 111011\ al ing fm1hl'r 1rlL"I\.O;I'-(·.. III im l·,lllIl·n1 As  changl'" in rd.lll\ l' prin" T ••hl..- I 11 '1' illl' ...·,lil11.II ..:d t\LIl"Hk.:COn()lllic  1Ill' clpllal ,,'ol:k in(fL·a.'>\..·". 11I )\\1,.·\I,.'I".:1Il incre:l ~ing  Ie  !pin .. 1(, I Ill" fn'llI L"illlli n :'l i(,n of If:ld ...· hafrier, !\()[l'lllal 1110.: l'~II III :lll'd Intl"L':I:-'l' in IIIl'I:, ll I"l':, 1 GDI'i, I ':;; IX·IH·111. II IlIIL' PI"Il"l"  :-.Iloult!  dL'chnl' (11  Ix-fcl'nl ElIlpl(l~Tlll"lIt i, L·~til11:llo.:d 10 incn::I~l' h~ 1 ,-": million TilL' CL'l'lllini fCj)01"l fUlll1t.'f L'x:llllil1l,... IhL"  ]"x III il III ( ,j" II )1:11 lin l'~IIlWI1! fl·p l. l("I,.·, dq)!"L"(';al ing l': lpil.d COll-",:,·qllt·Tltly. Iht: L"("III1I>1l1Y ""\'L'nlually 'l'l1k~ <il)\\ n \(, ,I m'\\ "1.II)k' kId /,1' GII)il :11 growt h Tili, llledllllll-IL'l"ln gfO\\ til I )( IIHI'" i, l:~li l1l;]IL'd 10 Ix.: hel\\I,.·L·1l (lo 1k"I"<:l'111 and H !"lL"I"t"l:nl ()rc~D P . Bald\\ in also .... 'tim.ltt..·.. :1 long-ll' fIIl grl)\"\lh  hent:fih frolll II n lil" .tlioll ill Ihl.: CI'l' o f ill<.."1"I.::I ......:<I  ! }(IIlU, 11:1"l.:d Oil a:-,:-,ulllp!ioll" 01 :1 lill·ofl.:liG limodd  gO\"L'l"IlIllL'nl " Ix.:ndmg F'P;lINolury I,"cd ]"}(,Iicil'" would I"}()o:-t 1'l':11 (;nl' gnll\llI \IP 10 -.'i rx.:rl<.:lll.  dl . . ·l1 ..  :md pr;(·I.:" \\ollid (kdllll.: h~ I j pCI"C1:1lI ' A Tl1or~' rL'H'm :-1IId~ h} HK ha1'd g,.ld\\ in  hy P;nti HOllh::r A("("ording [0 HOllie!". i f 11ll: "G Il!: :II"L' 1:lrgL' l ·1101l,l.:1l. till·ll l ·ap;I .•1 C:1n :K...llllllll:ill' indd"inildr I , ,\Il incn::t'o.: in Ihl.: I:C.. r:tl~ of  111\ l',lnll"l1l may lX" rl ll:Ull"lld y IIwl\.·a ...... ih growth  ( 19H"» ' U)!J.!l·'" Ih.t! Ihl' C~'(T hJn I rqx)]1 e~ l il11;t!e ... of 11ll" il1~r.... \......· ;11 (il1l' :\rl' 100 low B:lkl\\ in :1 'gllL"  111:\1 Ille Cl"n h ini 1\"1)(1n l1ukt", no .lllo\\:IIKl·  for till" d~ 11.11111(" ,l.:.un .. from ElifOpt.::m unit1L1li(lll. ,udl :I' Ihl' n'L' III 11,.'... hnolo,l.:ic.11 progrl'''-' dliL' 10 ,I ]x-rm:Illl"JU IlllfC\'l" III Ihl,.· 'Ill' 0 1 [he uurkl'! .\n 1I11port,lll! dIO\·I\.·lll·l· 1'1"1\\1,.·...:11 !he....· 1\\0 f.("()nomic H",\·i ... w - J 'III"~")' 1'J9 1  CecCh.n, I 1968 1001 ~ In ff".. s case  /lie fT/3tg"'3' prOdUCI 01 CiJP'lal does no/  o '",n.s"  "  Figure 2  Estimates of the Benefits to Europe from Unification Economic Output Ba\dw1n's  Iong-Ierm  growth bonus Baldwln's  medium-ltirm  growth """'" cacctJini Report Estimates  1992  TIme  mtc, as shown in Figure 2.' ~ Baldwin estimates that this pem1am::m increa."C in ~rowtb will be between 0.3 percent and 08 pern::nt. Adding up the Olliput cfft.'("\s, B~l klwil1 concludes that unification will to an t.'quivalent nne-time in GOP of hetween II pen.·eOl ;Ind 35 pcrcem. lt> Some L'eonoillists, on the OI:hcr h::IO(I, sUAAeSl that u.'Cl:hini"s grO\\th e ..timates :IfC actuall~' t(X) large In a n...·"(:cnt study, Menon Pt."(:k ( 1989) arglll..'s that the Ce<:<:hini n:pon oven...'Stimatcs the incrc-.tsc in output by a factor of two or thn..."e. Peck arrives at this conclusion in a r.lther arbitr:.try manner , howevcr. Pt.'Ck compare... the hypothesized growth in Europe from the elimination of tarif[o; on industrial producl.O; in 1968, estimated by Dennis Swa nn (984), with the curren t unification effon. Swann finds that e1iminm ion of t:lriffs on  t. The Economist  ( 1989a) prov.des 8 rncfI s(If1IfTI8ry of rhe  BaldWlfl study and ccmparcs hos grow"., eSIN'Tlales WIth Cecc/lJrns, as shown '" FogUffi 2 to  Baldwin (r989. 265)  to  ThIs study 1$ dcscrl/:1cd In CallI1f}a6l/ ( t988. 67)  .. Dafa aro svadable tot 8IfIvtJn 01 the rweM! [C.membet covn/IteS L~g has been eJ(CIudo1d from /fie table DeCausa dala wcro  flO(  IIvadaOie  imJustrial products inc(l,::ISt."'{1 gross n:Hlonal prodlKt (GNP) by I percent. Peck concludes, father arbitrarily, that because the pro]"X>,o;t.-d ehanges of tht! white paper are more extensive, the mino.. t.'Conomic gains shou ld he about 2 perecnt of GDP. '111e arbilrdriness of Pt.'ck·s <:(lnclusion is even more obvious bcC:l.uSC SW:lI1n's growth esti .. mate is small because tr.lde com]"X)St.-d ~llch a minor proponion of the EC"~ GNP in 1968 1- [nlt:r.. mllion:. l trade has pla)"t."'{1 an innt.'asing rok in the EC economy since that lime, hOWt'ver Exports and impon~ composed ;II>out 30 pen.·cnt of GDP in the EC in 1968 and rcacht.xl 50 percent by 1989 The results of:1 recent stlldy by O:lIa Resourt1..""S. Inc. (DIU) lend ~me m.:-dihility to Peck ·s vit!\v \hal the Ceccbini estimates arc too large. ORl's conclu.~ ions :m: also k:s.s f:lvo1"ah1l: th:ln those of the O:t"dlini n.:pon. This study c.~tim:ues gain.~ in GDI' o f ahout 0.5 percent by 1992 Accortling to DRI , employment should im:reilSt.' by 300,000 by 1995, one-.~ i xt h the siZe of the u.'C(:hini t.'Stimate. IJnfortunately, neither the DIU an:lly:-.i~ nor the tllodelth:lI sllppon.s it is avaibbic to the puhlit· hL'Cause it was prcP.'.I.rt.-d for DRl"s dienLS.I~ Distributional effects within Eu rope  nu,' gains to Europe from unifkation-regartl1es:-. of :-.ize-wi1l not he distrihuit.xl evenly :Kmss the EC. Because of regional disparitie:-., some areas will henefit more than others. Some;: cOllntrie~ may actually lose employment O f industries. as individuals and flmls move in search of h i ~her payi ng jobs or proximity to markets. Collntrks in tht! peri phery of Europe :Ire likely to 1"1':cciv<: the sillallest bencfits from Europe:lfl unification , and thcy may :1C11.I:llly lose in some cases. If these cOllntr ie.~ become dist'ollr:.tged, the pr(K<:."s of u nilk:uion may slow or even stop. M:my different economic variilbles will dt:tennine which :Ircas will be the greatest winners from unifiC"".tlion and which areas might int·ur problems. A recent :Inidc in 71JC Economist ( l990b ) mnks the EC-l1lcmbt.:r countries by estimated growth in the 1990s. This r.mking indudes the dYccts of Europe 1992, Germ an unific.ttion. :.lnti economic reforms in Ea:-.tem Europe. T:lble 2 IbLo; the economic variables that will detenninc the p:lUem of gro\\1h of EC-nwmher countries frolll Europe 1992 I~ 71)(' Economist r:mking. FL-dcnl ReKt"V<" Bank of Dalla!;  Table 2 Variables Affecting Which Member States Will Gain from European Unification Net Exports 01 Caplal  Good,  Hourty  Lat"" Costs West Germany Denmark Netherlands Belgium Italy France Britain Ireland Spain Greece Por1ugal  100 0 81.7 81.4 79.3 74.6 68.1 59.5 55 .7 43.0 29.1 181  InllallOn (percenl)  2.3 3.0 2. 1 3.2 5.8 32  9A 4.2 7.0 17.8 12.8  Total  Exports  (as a percentage of GOP)  3.9 .0 -1.6 - 2.2 1.0 -.3 .2 6.3  32.6 34.1 54.8 69.0 18.1 21 .5 23.3 72.0 19.5 24.4 33.0  Currenl Account  SA - 1.1  1.9 2.2 -1.4  -A - 3.4 1.4 -3.8 4.7 - 3.1  • Nel lmponer$ NOTE; These data are the lalest a~2.J laDle . •• cep1 the currllfll account. whICh os II 1990 forecast The data ,e4er 10 West Germany before u n,ficalic;m WI!h East Ger many  \\IUl.ll al"'I' I,t"...·.. IIltl) .KnJUIlI ""'p!)n ... I\J \X·I.·....I Germany a".1 ... h.ll"\.' of low l ",·xpor,... .Iocl ...·'poI1 ... 10 LI .. tern Europe .1 .... 1 ... 1l;1l\." of 10Ld .... Xpof,.... ,""[lIld \X· ...·...I (;ernlan~ III I .....· 1111.' .l-:I"...·;IIL·.. I \\ innL'!" in th .... 1l)I.}O:- . SpaIn \\ll l lk.·tll ...· n)unlr~ "ilh 111 ...·1(1\\l· ... 1 gfO\\111 fal ...... in til\' \1)<)0:-. :ll'l"ordin).: 10 Illl' al1,II\-"I'  '\ ("l"ordmg II) "1"1)/' I:"n 'lIt 'lIIisl. \\ il 11 inCf>:;",>:d r;tpil: tl 11(1\\"" 1[1\V .. tlll\: nt in bhor· inkn""\l' indu ... tr;...· ...... I\()ltid rll .. 1t II) .I fl·:!" \\"llh Ihl·I,)\\· ...... 1 \\:I.l-:e:- COltnlril· ... th;1l ;II\.· I1L" t.:xpon .... r ... o f 1.Iptlall-\004.t.... ",ulh :, .. \\c ... t t;l'rm;tny, Ir.... br1d. ;Ind 11:t1~. al\." \\dll"KI"lli{llll'd II) 1:lkt: :tdV:tlll;lg...· I lf Ihi .. inn...·.I .. 4.· tn ill\l·'t!tll'lll Onlile down "'Idc. 4.'ounlri ....... \\ illl high inlbltoll 1':111.' ... (l' :Illd (;1"1,: .... 4..4..) and (·11UIllri...,... \\ 1111 L1r.l-: ...· CUff",'\ll alUlllll1 ddinl ... ((;1"1•.'1.'1. ..... ""p;un. ,tnd lim.linl may Ix: Ltcin;..: "'lIppl~ con"lr.tlnh TII4.' ....... t'ourllnt'~ \\ 111 I'll..' 10..-..... Ii"d~ to Imro..-;I'.... pfodutllOn imnwdi;tldy \\ ilh 1110..' ",·'p.tnded lII,trJ..l.·tpl:tll.· .\ rllllJ,:h Lllh o(·I .lhl...-.! ... u).!,1!I..· ... t ... llI;u Ill,,·  ll"a(1...- :tnd  (·tJltntnl.·... 11.':1'-1 capahk of'l-t ;Id\';tnl;tge or Ihe g.ut) ... olk'rl'd from llni lk;llion :In: Bril;l in. Greece. l'or1ug:ll. :tnd Spain--<:ountrio,;· ... 11X"<lI .... d in th4.' r1<,: nphl'ry (If Ellfn]")\.: \\\· ...1 til'n n:my "'1;lncls Olll ;IS dw cOllnlr~ hI-.L·h to hl'11....,11 rt\o:-I from llnifiC:Hion . Onl' 0 1 IhL' tTlllcli 1...... U4.·... i~ \\ Ih:lhl.'r 11l11fkalUll] \\il l l.·X;ICl·rh;II ...· tll!TI.·[)l l ~ l·xi ... ti rl g n.·ginn:! l dl .. p;lri t i.... :- :·' bin lkgg (II.}I)(I) :Irglll':- Ih:\1 regio nal di ... p;lrili ....... \\ ill innl':I'>t' \\ ith lllli l"ic:ll ion. P:ll1kll1.1rI~ \\ 'ith ft: .. ,x:n to !:tho!" d1a r~ll"(l·!"i .. tk:-. In go.:.'[)I.' I~II. \\.1).:4.' ral ....... :U'l' IOWl·, t in th ...· 1)I:riphlTY of l:llrop4.·. " .. T;thle.! .. hu\\ . .. Pllflllg:ti. Grl.'o..:c~. :lnd ~P: 1l 11 hav .... Iht' 11)\\ 0..: ...1 \Va).:l.· 1':11 ...':-. \\ hile \X' t:S{ (;I.·rnl;ln~. l"knlll:trk .• lIlt! tl1\.· J\l·llh,:rbnd.., ha\ t: 111(: l1i)-:h ...·... \ wage ... in Ihl.'  rc \\ ,I)..:...'" 111  l'ortu)..::.1 arl..·  • SeeCa' "p<letl( 1988 68 lOJ Begg( J990IIJIldBean and others (1990. I': 16) lot mo,,, c/era.<ed d>SCUSSJ()r1$ 01 m·s ~~  "  les~ than one· fi fth the w;lge~ In West Gelmany One important re:I:>OI1 for the:>e W:lgc disp;!rilics i:> that wages renl;.'Ct differing ..kill levels. An()(her irnpot1:lnt rea:>oo for the wage d i:>parities is Ihat :1 comhination of demographic pressures :md irnrx-diml.'nt~ to !:thor mohility have GHI!>L-"d high uncmplo}'lllent rates i n Ihe (X!riphery. Wages for a given skill level. therefore, an~ l()\ver in the (X!riph{.·ry than in thl.! <':OI"C In the past, migr.llion of unskilled bbor ha~ alkviai(.-xi somL', but not all, of this imh:d:mn:. TIle whitc papc.:r proposals, however. conI.."entr.:lle on i n(·re:lsi ng the mohi lity or skilled Ia hor. Begs arglles that the increased mobiliTY or skilled, proressional, :md m:magerial workers may C:lUse tilt: peripheral regions to lose skilled labor. increasing the disparity in aver:lgc sk ill levels across cOllntries. In<.:reaSt.-xi finn mobility also affects the disTri bution of gains rrom Euro(X!:m unificati on. I3cgg argues that finns subje(.."t to in(.."rea~ing returns to SClle will move to COllntrie:> with larger domcstic markets. A pattern will emerge in w hich finns :>uJr jt.."Ct to innC'.J.sing return..; move to central loc.llion-;. while IL'ss dyn:Ullic indlLstrie~ remain in the periph· ery. As the (."o n(·cntration of pmdU(1ion and d istrihution facilities increase:o. in the core, the gains from ~Gde c..--COllOmic..":o. and proximit)' to markets will ofTst:t finns· CO!'>t o f hiRher wage:o. and conge<>l ion. Begs concludes that thc p attern of gains from European un ific.::Llion fa\'or the core regions. 'nl is partem results from the geneml fact that the past econo m ic perform:loce of the periphery identifies these area s as rdath'f...'ly un(·ompetitive. T hus. the compet iTively weak (·ountries will ga in the le:lst, and perhaps lo.'>C. from EC integration.  Conclu..<;ion T he EC has much to g:l in hy hecoming a unified m:l rket by the cnd o f 1992 The barriers TO tr.:lde that currently exi."t in Europe distort m arkets and Icad to inefficiencies in pn.xluctio n. By removing the~e restrictions, the EC has the opponll'  nity to invigor:l1e it .. economy and im prove its [X>:>ition in the world econom y. The removal of intr.l-EC trade impediments dctTf...' costs dire('tly. A-; finns exp:tnd their mmkets. they become more (·o lllpetitivc and ex· ploit SC'.lle econom ic:,. Co...;", dC("fe:lsc funher. OcdininR costs tr:lI1!>latc into falling prices and in("fL'asing demand. Im: reased profitahility raises inve." lment lllis stimulates ~rowth :lIld lead!> to grcater inve:,tment and fun her growlh On the other hand , e\en though removal of intrJ-EC tr.lde harriers will lead to gll..'ater efficiencies in somt: m:l rkets, it lll:lY CallSI..' new inefficien· des in other Ill:lrkets. If the EC maintains its high exlern;d trade harriers. or perhaps increases them, unifkalion may Ic ad to tr:lde d iversion. Countries will switch from purchasing goods from the most drk-ient produ(.."ers OutSide the EC to purchasing these goods from less efficient producers inside the EC. I n this case, the removal of intr:I-EC trade restrktions allow L'xternal·EC trade harriers to d i:o.tort m:l rkets. One question remains u nanswered: Will Europe rt.--ach its gO:11 :md hecome a unified market hy 1992? Of the approximate 300 p roposa ls set fonh in the white paper in 19H5. the Commission had begun negotiations on 60 percent of them by July 19W.l1 Only 121 of these had Ix.'i:n formally :Ldoptf...-d :1l that time. Little progres....; has been 1ll:lde in the areas o f l iher:llizi ng the mohility of (X'up lc and unifying indirt.'Ct taxatio n schemes, health st:lOdards. and price suppons set by the Common Agricllltllr.:11 Polity These areas will not likely be rcsolvcd by tllc cnd o f 1992Y Eun)pe 1992 is not an t:vcnt ; if is an ongoing process. Although the EC may not meet :111 the goal.-; .-;et fonh in the w h ite p:qx:r hy the end of 1992, it will have made progre.-;s in liberalizing trade $u(.."(."ess in removing b:lrriel"S will be greater in some art::ts-the ;lrcas with Ics..~ po litical friclion- t han in uthe." This process of liberalization will con tinue I.>t:}'o nd 1992. 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