American Economic Association

In Honor of Lawrence H. Summers, Winner of the John Bates Clark Medal

Author(s): James M. Poterba
Source: The Journal of Economic Perspectives, Vol. 9, No. 1 (Winter, 1995), pp. 165-182
Published by: American Economic Association
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Journal of Economic Perspectives- Volume 9, Number I -Winter 1995- Pages 165-182

In Honor of Lawrence H. Summers,

Winner of the John Bates Clark Medal

James M. Poterba

L awrence Henry Summers is the 1993 recipient of the John Bates Clark
Medal, an award presented by the American Economic Association
every other year to an outstanding economist under the age of forty.
Larry is an extraordinary research economist, as well as an active participant in
economic policymaking, and to some degree a political figure. He served as a
Staff Economist at the Council of Economic Advisers (1981-82), Chief Economist
of the World Bank (1989-91), and is currently the Under-Secretary for Inter-
national Affairs at the U.S. Treasury.
This paper summarizes Larry's important research contributions.' The
next four sections describe his work in the four fields of economics that were
identified in the Clark Medal citation: public finance, labor economics, financial
economics, and macroeconomics.2 Each section describes his substantive re-
search contributions, and discusses novel aspects of his research strategy. The
sheer quantity of Larry's published work has forced me to limit this survey to a
fraction of his research, and I apologize at the outset to Larry, and his
coauthors, for oversights or errors of omission. As is typical of papers of this

IReaders interested in other aspects of Larry's career may wish to consult articles in the Boston
Globe Sunday Magazine, 12 October 1986, the New YorkTimes, 27 October 1991, Business Week, 11
May 1992, or the WashingtonPost, 27 June 1993.
2The Clark Medal citation is printed in the May 1994 issue of the AmericanEconomicReview: Papers
and Proceedings, p. 460.

*James M. Poterba is Professor of Economics,MassachusettsInstitute of Technology,

and Research Associate, National Bureau of Economic Research, both in Cambridge,
Massachusetts.This paper was writtenwhile he was a Fellow at the Centerfor Advanced
Study in the Behavioral Sciences, Stanford, California.
166 Journal of Economic Perspectives

sort in this journal, Larry's papers that are referenced in this article are listed in
chronological order in Table 1 and referred to by number in the text. All other
references are by the author-date approach.

Public Finance and Capital Income Taxation

Larry's long-lasting interest in public finance was sparked by his research

interaction with Martin Feldstein. This began when Larry, an MIT undergrad-
uate, worked as a summer research assistant for Feldstein, a Harvard professor,
in 1974. They subsequently collaborated during Larry's graduate school years
at Harvard, and published two papers on taxation, inflation, and corporate
profits. Larry's doctoral dissertation (which was advised by Feldstein) and his
first major publication were concerned with the economic analysis of capital
income taxation. Feldstein's approach to empirical economics played a critical
role in shaping Larry's research style, and its durable influence is clear in much
of the research discussed below.
After Larry had accepted an assistant professorship at MIT, Feldstein and
Summers published a joint paper [1] which showed that high inflation rates
raised the total tax burden on corporate capital income to levels far above the
statutory corporate tax rate. In some years, this tax burden exceeded 70
percent. This was due to three factors: the use of nominal rather than real
values in computing tax depreciation deductions on corporate assets, the
taxation of nominal rather than real profits on goods held in inventory, and the
taxation of investors on nominal rather than real interest payments and capital
gains.
Larry moved beyond simply documenting high effective tax rates to ana-
lyze how such taxes were likely to affect saving and capital formation. Although
the argument that inflation raised tax burdens and depressed after-tax returns
was widely accepted in the late 1970s, there was less agreement concerning the
empirical link between after-tax returns and saving behavior. The prevailing
wisdom held that saving was relatively insensitive to rates of return, since in the
standard two-period Fisherian analysis, a reduction in the rate of return
induces offsetting income and substitution effects. Michael Boskin (1978) had
presented striking, if controversial, evidence to challenge this view, showing
that lower after-tax interest rates significantly lowered U.S. private saving.
Larry was drawn to this controversy. He recognized that when analyzing
capital income taxation, there was an important distinction between the stylized
two-period model and more realistic multiperiod models. Since actual house-
holds live for many periods and expect to receive labor income in future
periods, reductions in the after-tax rate of return raise the present discounted
value of their future labor income. This positive human wealth effect raises
current consumption, reinforcing the substitution effect that favors current
over future consumption when rates of return decline.
 JamesM. Poterba 167

Table I
Forty Selected Papers by Lawrence H. Summers

1. "Inflation and the Taxation of Capital Income in the Corporate Sector" (with Martin S.
Feldstein), National Tax Journal, December 1979, 32, 330-55.
2. "Labor Market Dynamics and Unemployment: A Reconsideration" (with Kim B. Clark),
BrookingsPapers on EconomicActivity, 1979, 1, 13-60.
3. "The Labour Scarcity Controversy Revisited" (with Richard N. Clarke), Economic Journal,
March 1980, 90, 129-39.
4. "Taxation and Corporate Investment: A Q-Theory Approach," Brookings Papers on Economic
Activity, 1981, 1, 67-127.
5. "The Role of Intergenerational Transfers in Aggregate Capital Accumulation" (with Laurence
J. Kotlikoff), Journal of Political Economy,August 1981, 89, 706-32.
6. "Capital Taxation and Accumulation in a Life Cycle Growth Model," AmericanEconomicReview,
September 1981, 71, 533-44.
7. "Inflation and the Valuation of Corporate Equities," NBER Working Paper 829, Cambridge,
1982.
8. "Labour Force Participation: Timing and Persistence" (with Kim B. Clark), Review of Economic
Studies, 1982, special issue, 49, 825-44.
9. "Dividend Taxes, Corporate Investment, and Q" (with James M. Poterba), Journal of Public
Economics,November 1983, 22, 135-67.
10. "Tax Reform and Corporate Investment: A Microeconomic Simulation Study" (with Michael
Salinger). In Feldstein, Martin S., ed., Behavioral Simulation Methods in Tax Policy Analysis.
Chicago: University of Chicago Press, 1983, 247-87.
11. "The Nonadjustment of Nominal Interest Rates." In Tobin, James, ed., Macroeconomics,Prices,
and Quantities. Washington: Brookings Institution, 1983, 201-41.
12. "The Asset Price Approach to the Analysis of Capital Income Taxation," Proceedings of the 76th
Annual Meeting of the National Tax Association-Tax Institute of America, Columbus, Ohio, 1983,
112-20.
13. "The Taxation of Risky Assets" (with Jeremy Bulow), Journal of Political Economy, February
1984, 92, 20-39.
14. "The Strategic Bequest Motive" (with B. Douglas Bernheim and Andrei Shleifer), Journal of
Political Economy,December 1985, 93, 1045-76.
15. "Intertemporal Substitution in Macroeconomics" (with N. Gregory Mankiw and Julio Rotem-
berg), QuarterlyJournal of Economics, February 1985, 100, 225-52.
16. "A Theory of Dual Labor Markets with Applications to Industrial Policy, Discrimination, and
Keynesian Unemployment" (with Jeremy I. Bulow), Journal of LaborEconomics,July 1986, Part
1, 4, 376-414.
17. "Adjusting the Gross Changes Data: Implications for Labor Market Dynamics" (with James M.
Poterba), Econometrica,November 1986, 54, 1319-38.
18. "Does the Stock Market Rationally Reflect Fundamental Values?" Journal of Finance, July 1986,
41, 591-601.
19. "Hysteresis and the European Unemployment Problem" (with Olivier Blanchard). In Fischer,
S., ed., NBER MacroeconomicsAnnual. Cambridge: MIT Press, 1986 15-78.
20. "A Tax-Based Test for Nominal Rigidities" (with James M. Poterba and Julio J. Rotemberg),
AmericanEconomicReview, September 1986, 76, 659-75.
21. "Is Increased Price Flexibility Stabilizing?" (with J. Bradford DeLong), American Economic
Review, December 1986, 76, 1031-44.
22. "Public Policy Implications of Declining Old Age Mortality"' (with James M. Poterba). In
Burtless, Gary, ed., Work, Health, and IncomeAmong the Elderly. Washington: Brookings Institu-
tion, 1986, 19-59.
23. "A Fair Tax Act That's Bad for Business," Harvard Business Review, March 1987, 65, 53-59.
168 Journal of EconomicPerspectives

Table I
Continued

24. "Fiscal Increasing Returns, Hysteresis, Real Wages, and Unemployment" (with Olivier J.
Blanchard), European EconomicReview, April 1987, 31, 543-66.
25. "EfficiencyWages and the Inter-IndustryWage Structure"(with Alan B. Krueger), Economet-
rica, March 1987, 55, 259-93.
26. "Did Henry Ford Pay EfficiencyWages?"(with Daniel Raff),Journalof LaborEconomics,
October
1987, 5, S57-S86.
27. "The Gibson Paradox and the Gold Standard"(with Robert B. Barsky), Journal of Political
Economy, June 1988, 96, 528-50.
28. "MeanReversionin Stock Prices:Evidenceand Implications"(withJames M. Poterba),Journal
of Financial Economics,October 1988, 22, 27-59.
29. "The Costs of Conflict Resolutionand FinancialDistress:Evidence from the Texaco-Pennzoil
Litigation"(with David M. Cutler), RANDJournalof Economics,Summer 1988, 19, 157-72.
30. "Breach of Trust in Hostile Takeovers" (with Andrei Shleifer). In Auerbach, Alan, ed.,
CorporateTakeovers:Causesand Consequences.Chicago: University of Chicago Press, 1988, 33-67.
31. "WhatMoves Stock Prices?"(with David M. Cutler and James M. Poterba),Journalof Portfolio
Management, Spring 1989, 15, 4-12.
32. "Tax Policy, Asset Prices, and Growth:A General EquilibriumAnalysis"(with Lawrence H.
Goulder), Journal of Public Economics,April 1989, 38, 265-96.
33. "Some Simple Economics of Mandated Benefits," AmericanEconomicReview,May 1989, 79,
177-83.
34. "Industry Rents: Evidence and Implications"(with Lawrence F. Katz), BrookingsPaperson
EconomicActivity:Microeconomics,1989, 209-75.
35. "Noise Trader Risk in Financial Markets"(with J. Bradford DeLong, Andrei Shleifer, and
Robert Waldmann), Journal of Political Economy,August 1990, 98, 703-38.
36. "The Noise Trader Approach to Finance"(with Andrei Shleifer), Journalof EconomicPerspec-
tives,Spring 1990, 4, 19-33.
37. "Inflexible Prices and ProcyclicalProductivity"(with Julio J. Rotemberg), Quarterly
Journalof
Economics,November 1990, 105, 851-74.
38. "EquipmentInvestment and Economic Growth"(with J. Bradford DeLong), Quarterly
Journal
of Economics,
May 1991, 106, 445-502.
39. "Consumption Growth Parallels Income Growth" (with Chris Carroll). In Bernheim, B.
Douglas, and John B. Shoven, eds., National Saving and Economic Performance. Chicago:
Universityof Chicago Press, 1991, 305-43.
40. "The StructuralAdjustmentDebate"(with Lant H. Pritchett),AmericanEconomicReview,May
1993, 83, 383-89.

In his pathbreaking paper on life-cycle saving [61, Larry used the life-cycle
growth model developed by Tobin (1967) to illustrate the importance of this
human wealth effect. For plausible parameter values, he found that it was
possible to obtain interest elasticities of saving even larger than Boskin's (1978)
econometric estimates. His results implied that changes in after-tax returns
could have large effects on the flow of saving and investment. Subsequent
empirical work, such as that by Robert Hall (1988), suggests that such large
responses are not borne out by historical experience, but Larry's work remains
an important challenge to these findings.
Although the two projects described above were completed while Larry
was in graduate school, neither was included in his doctoral dissertation. His
 In Honorof LawrenceH. Summers 169

Lawrence H. Summers

dissertation, which focused on other issues in capital income taxation, was

submitted to Harvard three years after Larry left graduate school, in the same
year that he accepted a tenured Harvard professorship. It included four studies
that have significantly influenced subsequent research in public finance.
The first part of Larry's dissertation, published as [4], used the q-theory
framework developed by James Tobin (1969) to explore the incentive and
incidence effects of taxes on corporate capital income. This landmark study
contained several important contributions. First, it developed a rigorous foun-
dation for a linear investment equation based on Tobin's q theory, which
argues that corporate investment decisions can be explained by the ratio of the
stock market's current value and the replacement cost of corporate assets.
Larry's analytical framework has become the basis for many subsequent studies
using both aggregate time-series data as well as firm-level panel data.
Second, this study introduced tax policy variables to the q-investment
framework and provided important new estimates of how tax policy affects
investment. Although investment research in the neoclassical accelerator frame-
work, beginning with Hall and Dale Jorgenson (1967), had recognized the
importance of modelling tax incentives, previous empirical studies in the
q-theory tradition had ignored taxes. Larry not only introduced taxes to the
theory, but also showed that incorporating taxes substantially improved the fit
of aggregate investment equations. His estimates of how tax policies affect
investment, based on aggregate time series data in [4] and firm level data in a
parallel study with Michael Salinger [10], are still widely used in assessing
various government policies to stimulate investment.
170 Journal of EconomicPerspectives

Finally, this study developed what has become known as the "asset price
approach" to incidence analysis. As Larry explains in [12], previous analyses of
the incidence of differential tax burdens on different types of capital had
employed Arnold Harberger's (1962) framework, in which capital is freely
mobile between heavily taxed and lightly taxed sectors. Equilibrium therefore
requires that investors are indifferent between investing in different sectors.
This implies that altering the tax burden on one type of capital changes the
equilibrium return to all capital, whether in the heavily taxed or the lightly
taxed sector.
Larry argued that the assumption of complete capital mobility suppressed
the short-run revaluation effects that occur when tax reforms alter the tax
burdens on capital assets already in place in different sectors. More impor-
tantly, he showed that these revaluation effects were large and were likely to
represent a critical part of the actual incidence of most tax reforms. Focusing
on the asset-price effects of tax changes also yielded new prescriptions for tax
policy design, such as avoiding the creation of windfalls for existing asset
holders. Larry illustrated this point by comparing two policies that reduce the
cost of capital to firms: a reduction in the corporate tax rate and an increase in
the rate of investment tax credit. Reducing the corporate income tax rate
would raise the after-tax return on existing corporate capital assets, thereby
generating a windfall for the holders of such "old capital," while an investment
tax credit would subsidize new investment, without any associated windfall to
holders of existing assets.3
A second study in Larry's dissertation addressed a fundamental question in
macroeconomics and finance, which is also critical for evaluating how changes
in inflation affect after-tax returns. This is the extent to which nominal interest
rates respond to changes in inflationary expectations. Larry's influential study
[11] of U.S. historical experience found, contrary to Irving Fisher's (1930)
prediction and nearly 50 years of prevailing wisdom, that nominal interest rates
did not rise point-for-point with expected inflation: they rose much less. Higher
inflation rates therefore reduced the real after-tax return to saving by mor-e
than standard analyses of the inflation-and-taxes interaction, such as Feldstein
(1976), suggested.4 More generally, these findings raised questions about the

3To evaluate the asset price effects of tax changes in perfect-foresight growth models, Larry needed
to find numerical solutions to asset price trajectories in plausibly calibrated saddlepoint-stable
rational expectations models. These models had previously been studied exclusively with analytical
phase-diagram methods. Larry's paper on investment [4] and David Lipton and Jeffrey Sachs'
(1983) analysis of exchange rate determination were the first studies to demonstrate that such
models could be used as the foundation for quantitative analysis of policy shocks. Numerous
subsequent studies have followed in this tradition.
4Summers and Robert Barsky [27] subsequently developed a model to explain the determination of
real interest rates under the gold standard. They applied this model to explaining "Gibson's
Paradox," the observed correlation between the nominal interest rate and the price level during the
gold standard period in the United States.
 James M. Poterba 171

rationality of financial markets, a subject that Larry returned to in research

described below.
A third component of Larry's dissertation research focused on how taxes
on dividends and capital gains affect investment incentives. Modelling the
effects of such taxes is complicated by the lack of agreement on what explains
some critical aspects of corporate financial policy. For example, Fischer Black
(1976) labelled the high and stable pattern of corporate dividend payouts the
"dividend puzzle," because many shareholders face higher tax burdens on
dividend income than on capital gains. These investors would earn higher
after-tax returns if firms retained and reinvested earnings, or repurchased
their shares, rather than paying dividends.
Because firm financial policies are important determinants of the total tax
burden on corporate capital income, the economic effects of dividend taxes
have attracted substantial attention from public finance economists. Alan Auer-
bach (1979), David Bradford (1981), and Mervyn King (1977) independently
developed an analysis of the incidence of dividend taxes under the assumption
that firms face binding constraints on their ability to repurchase shares. This
has become known as the "trapped equity" model, and it implies that in-
creases in dividend taxes have no effect on the cost of capital. Because firms are
constrained to pay dividends, such taxes are a lump suin tax on existing
share holders.
Larry and I [9] analyzed the incidence of dividend taxes in an alternative to
the trapped equity model, in which firms pay dividends in spite of their tax
disadvantage, because they generate something of value to investors. Such
value might arise from information transmission, if dividends provide informa-
tion on the firm's cash flow position, or it might derive froni a reduced need to
sell shares to finance potential consumption needs. Our empirical analysis of
firm behavior in the United Kingdom, where the tax burden on dividends and
capital gains changed several times during the 1950-1980 period, suggested
that this "traditional" model substantially outperformed the trapped equity
model. These results suggested that higher dividend taxes in fact raised the cost
of capital and discouraged investment.
Finally, Larry's dissertation included another section that analyzed whether
the interaction between rising inflation rates and the unindexed tax code was
responsible for the decline in the real value of the stock market during the
1970s [7]. This chapter, which was never submitted to a journal, found that
inflation-induced increases in corporate tax burdens could explain as much as
one-third of the stock market's real decline during the 1970s. These results
provided important empirical support for the asset price approach to incidence
analysis.
Larry's interest in research questions associated with capital income
taxation has continued throughout his career. With Jeremy Bulow [13], he
examined the long-standing question of how capital income taxation affects
incentives for risk taking. Bulow and Summers showed that, because tax
172 Journal of EconomicPerspectives

depreciation allowances are specified as a function of an asset's purchase price

even though most assets' resale values fluctuate widely over their lifetimes,
existing depreciation policies discourage investment in risky assets.
In joint work with Lawrence Goulder [32], Larry also developed a multi-
sector general equilibrium model that incorporates both asset price dynamics
and rich detail on the production and consumption structure of the economy.
This model represents the state of the art in analyzing the asset revaluations
associated with tax reform. Larry's more recent research on the social externali-
ties of equipment investment also bears on the design of capital income taxes.
Larry argued in [23] that if some assets generate greater externalities than
others, then the stated objective of the Tax Reform Act of 1986, "levelling the
playing field" by placing equal effective tax rates on all assets, may be inappro-
priate. His recent empirical work, described in more detail below, suggests the
potential importance of this argument.

Labor Economics and Unemployment

A second major component of Larry's research portfolio focuses on labor

economics, particularly macroeconomic aspects of labor market activity. During
the mid-1970s, several influential studies, such as Feldstein (1975) and Hall
(1972), developed a "turnover" view of the U.S. labor market. These studies
showed that there was a high probability that an individual would move
between employment and unemployment in a given year, and also documented
high month-to-month exit rates from unemployment. This research was inter-
preted as suggesting that the welfare cost of unemployment was relatively low,
since most unemployment spells were of short duration.
In 1978, supported by a $4,500 research grant from the Assistant Secretary
for Policy Evaluation and Research at the U.S. Department of Labor, Larry
collaborated with fellow graduate student Kim Clark on a project examining
the dynamics of labor market activity. In a blockbuster paper that remains a
standard reference, Clark and Summers [2] challenged, and largely debunked,
the turnover view.
First, Clark and Summers drew attention to the labor market analogue of
an important result in renewal theory. Even if most of the individuals who
experience unemployment over the course of a year experience short unem-
ployment spells, it is still possible that most unemployed individuals at any
point in time are in the midst of long spells. This occurs because the pool of
unemployed individuals at each moment includes a higher proportion of those
suffering long spells of unemployment than those suffering only short spells.
Second, Clark and Summers used newly released data from matched
Current Population Survey tapes, as well as unpublished data on labor market
gross flows, to show that many of the individuals who exited unemployment in
one month became unemployed again in the following month. This reflected a
 In Honor of Lawrence H. Summers 173

combination of poor definition of the boundary between unemployment and

not-in-the-labor force, a high rate of measurement error, and the relatively
short expected duration of many jobs that unemployed workers find. This
finding undermined a key component of the turnover view of unemployment,
because it suggested that the probability of becoming unemployed was related
to previous unemployment experience, and not "memoryless." It suggested
that the actual concentration of unemployment spells was greater than that
predicted by probabilistic models in which previous unemployment experience
is unrelated to current experience.
A related line of inquiry reinforced the attack on the turnover view of
unemployment. In a joint paper [17], Larry and I used data from the Current
Population Survey Reinterview Survey to estimate the incidence of response
errors in the gross flows data. Our findings showed that errors were prevalent,
especially in misclassification of unemployed individuals as out-of-the-labor
force. We developed an algorithm that used the Reinterview Survey to "adjust"
the monthly flows data, and found that the degree of labor market dynamism
was far lower than early advocates of the turnover view believed.
Larry has also conducted research on the role of the labor market in
aggregate economic fluctuations. Clark and Summers [8] tested Robert Lucas
and Leonard Rapping's (1969) hypothesis that labor market fluctuations could
be explained by intertemporal substitution of labor supply. They studied
whether the increase in women's labor force participation during World War II
had persistent effects on women's labor supply. Movement into the labor force
was followed by continued labor force participation, not by labor market
withdrawal as the intertemporal substitution hypothesis would suggest. This
paper is a prime example of one aspect of Larry's empirical research style, his
search for exogenous shocks that can reveal important information about
economic questions.
N. Gregory Mankiw, Julio Rotemberg, and Summers [15] presented fur-
ther evidence contradicting the intertemporal substitution hypothesis. They
observed that consumption is procyclical, while leisure is countercyclical. This
makes it difficult to explain aggregate labor market fluctuations on the basis of
representative consumer models in which consumption and leisure are comple-
ments. This finding is one of the stimuli to the substantial and growing
literature that emphasizes non-separabilities in utility functions, habit persis-
tence, and richer models of labor market institutions as ways to explain the
observed covariation of hours and consumption.
An additional line of research on labor markets, also motivated by ques-
tions of macroeconomic adjustment, focuses on "efficiency wages." Larry's first
paper on this subject was a theoretical analysis with Bulow [16]. This paper
applied the framework developed by Carl Shapiro and Joseph Stiglitz (1984) to
study a wide range of applied issues in labor economics. It showed that when
imperfect monitoring of worker effort leads firms to pay wages in excess of a
worker's opportunity cost, and to fire those workers who are caught shirking,
174 Journal of Economic Perspectives

many standard properties of well-functioning neoclassical labor markets must

be qualified. Involuntary unemployment is possible, raising the minimum wage
may increase social welfare, and there may be a justification for government
intervention to protect particular industries.
In later work with Lawrence Katz [34], Larry applied a similar framework
to study the labor market effects of international competition. Katz and Sum-
mers argued that being rationed into employment in a low-wage sector is
similar to being rationed into unemployment, and therefore suggested that
trade policies that affect the sectoral composition of domestic employment can
have important welfare effects.
Because so many issues of labor market analysis turn on whether firms pay
efficiency wages, Larry also carried out empirical studies directed at this issue.
His work with Alan Krueger [25] studied the nature of interindustry wage
differentials and showed that there are important "industry effects" in wage
equations estimated using individual-level data, even after controlling for indi-
vidual and job characteristics. In effect, this study shows that there are high-wage
and low-wage industries and that these differences affect workers in most
occupations within these industries. It has attracted numerous extensions and
remains one of the key sources of empirical support for efficiency wage models.
A related study with Daniel Raff [26] drew on historical analysis of the Ford
Motor Company's experience when Henry Ford decided to raise his factory's
daily wage to $5, well above prevailing local wages. Raff and Summers mar-
shalled evidence consistent with efficiency wage models and suggested that the
productivity of Ford workers increased when wages were raised.
Larry's skill in analyzing both labor markets and public policy is also
displayed in a brief study, [33], comparing the incentive effects of government
mandates that employers provide certain private goods with the alternative of
tax-financed government provision of these goods. This paper, which antici-
pated the current health care reform debate by several years, showed that
mandated benefits could be more efficient than tax-financed government
spending. This finding has attracted substantial attention and stimulated fur-
ther work as the prospect for new government mandates has grown.

Financial Economics

Financial economics, and the interplay between macroeconomics and fi-

nance, has been one of Larry's enduring research interests. Much of his
research on capital income taxation was stimulated by the search for rational
explanations of the substantial decline in real U.S. equity values during the
1970s. In the early 1980s, Larry's interest turned to a number of issues that are
primarily within the purview of financial economics.
Larry's first important contribution to financial economics, [18], explored
the evidentiary basis for the common view that stock markets are efficient. This
 JamesM. Poterba 175

paper, written in 1981, was summarily rejected by the Journal of Finance. Five
years later, when Black was president of the American Finance Association, he
invited Larry to present it at the AFA meetings, and included it in the
proceedings issue of the Journal of Finance. In conjunction with research by
Robert Shiller (1981) and others on asset price fluctuations, this work has had a
substantial subsequent impact on financial economics.
Larry's paper on market efficiency showed that although numerous empir-
ical studies had failed to reject the random walk theory of stock prices, most of
their empirical tests had very low power against an important set of alternative
models of asset price determination with very different implications for market
efficiency. Larry examined the case in which asset prices are the sum of two
components, one a random walk and the other a slowly decaying, mean-
reverting random variable. He showed that if the mean-reverting component
decayed slowly enough, standard tests of whether asset prices follow a random
walk would fail to reject the null hypothesis unless the underlying data set
spanned a far longer time period than any existing data set on asset returns.
This paper challenged one of the central empirical canons of financial
economics.
Larry's subsequent research extended his analysis of market efficiency in
two directions: searching for empirical evidence of deviations from random
walk behavior in asset prices, and developing models of asset price formation in
which investor sentiment and other factors lead prices to deviate from their
fundamental values.
Larry's work on the empirical properties of asset returns began with our
joint paper, [28], which demonstrated that stock prices in the United States
exhibit a significant degree of mean reversion. While this was not apparent in
studies that had focused on predicting daily or monthly stock returns from
their own recent lagged values, it was clear in our analysis of longer-horizon
stock returns. We showed, for example, that the variability of stock returns over
horizons of eight years was only about half as great as it would be if each year's
return was statistically independent of all other returns.
The empirical findings in this study and others that have been published
since the mid-1980s have largely overturned the previous conventional wisdom
in financial economics. There is now a broad concensus that asset returns are,
in part, predictable, and research attention has shifted to the question of why
this is so. Since equilibrium returns may fluctuate over time, predictability per se
is not inconsistent with market efficiency. Current research, surveyed in
Eugene Fama (1991), is directed at this question.
Larry's second line of research on market efficiency has focused on the
impact of "noise traders" in financial markets. The premise of this research
program is that some participants in financial markets decide which assets to
purchase on the basis of information other than the rational expected present
discounted value of future cash flows. These investors may be affected by
swings of sentiment, by misguided extrapolation of past returns to the future,
or by a range of other factors. Even the most devoted efficient market
176 Journal of EconomicPerspectives

proponent will acknowledge that such investors exist; everyone has a relative
who has a "hot tip."
The central economic question is whether noise traders affect asset prices.
Most financial economists follow Milton Friedman (1953) in dismissing such
traders. Friedman argued that uninformed investors cannot outperform more
rational investors, so their wealth and market influence must decline over time
and asymptotically vanish. J. Bradford DeLong, Andrei Shleifer, Summers, and
Robert Waldmann [35] challenged this view. They showed that the presence of
noise traders in a market can increase the volatility of asset prices, thereby
discouraging rational traders from participating in the market and arbitraging
prices to their rational values.
Summers and his coauthors developed an ingenious framework both for
introducing noise traders to financial markets and for analyzing the compara-
tive static properties of changes in the trading environment. They explored the
role of investor sentiment and limited arbitrage opportunities in a series of
related papers, summarized in Shleifer and Summers [36]. In particular, they
called attention to the possibility that some investors follow positive feedback
investment strategies, such as basing their predictions of future returns on past
returns, that may generate substantial "noise trader risk" in financial markets.
One empirical project that provided some empirical support for the "noise
trader" view was David Cutler, Larry, and my project [31] on the source of
stock price movements. Stimulated by the puzzling events of October 1987, this
study analyzed the individual days on which the U.S. stock market recorded its
largest gains and losses, and then searched for associated news events that
could justify such price moves. In most cases, it proved difficult to identify any
such news. Running the same experiment in reverse showed that days with
substantial news, such as elections, assassinations, or similar events, were not
outliers when measured by the absolute value of stock market returns.
Along with these projects on asset pricing, Larry has also done important
work in corporate finance. Two studies deserve particular note. One, with
Cutler [29], exploited the "natural experiment" provided by the Texaco-
Pennzoil litigation of the mid-1980s to estimate the costs of financial distress.
The Texaco-Pennzoil battle was a lawsuit over damages from a failed takeover
attempt. Pennzoil received a $10 billion jury award in a Texas court, and, in a
protracted legal battle, Texaco took various measures to avoid paying this
settlement. At one stage, Texaco filed for bankruptcy protection.
Cutler and Summers' key insight was that this dispute was a zero sum
game between Pennzoil and Texaco, except for the potential legal and business
costs of operating a large firm on the verge of bankruptcy. By comparing the
gain in Pennzoil's market value with the loss in Texaco's value, they estimated
that bankruptcy costs could be as much as 30 percent of the value of the jury
award.
A second project in corporate finance focused on the social gains associated
with hostile takeovers. The takeover wave of the 1980s sparked numerous
 In Honor of Lawrence H. Summers 177

questions about the net benefits of such corporate control transactions. Work-
ers at target firms were sometimes displaced, but takeover proponents such as
Michael Jensen (1988) argued that the increase in the market value of target
firms represented an improvement in efficiency that ultimately worked to
society's benefit. In a paper coauthored with Shleifer [30], Larry observed that
some of the target shareholders' gain could come at the expense of other
corporate "stakeholders" whose implicit contracts were abrogated, and illus-
trated this possibility with several case studies. This paper incited an acrimo-
nious debate on the merits of hostile takeovers. Its durable contribution is the
important insight that stockholder gains are not the same as social welfare
gains.

Macroeconomics and Economic Fluctuations

Virtually all of Larry's research in public finance, labor economics, and

financial economics has been concerned with macroeconomic issues. Larry has
also carried out a number of projects with a more exclusive macroeconomic
focus. This section describes four strands of this research.
Persistent high unemployment rates in the major European economies
during the 1980s constitute an important challenge to standard theories of
macroeconomic adjustment. This led Olivier Blanchard and Summers to un-
dertake a substantial research program designed to explain the apparent
failure of standard equilibration mechanisms in European macroeconomies. In
[19], they proposed the "hysteresis" explanation of persistent unemployment.
They argued that as a result of a number of stylized features of actual labor
markets, such as insider control of unions and human capital decay during
periods of unemployment, aggregate demand shocks could have long-lived
effects. This research suggested that the natural rate of unemployment at any
moment depended on the past history of unemployment.
Blanchard and Summers showed that the "hysteresis" view altered tradi-
tional analyses of fiscal policy, and argued that tax cuts might be self-financing
for some European nations. In later work [24], they developed the notion of
"fiscal increasing returns." They showed that increasing returns from the
production function itself, or arising from potential reductions in tax rates
when output expands, can obviate the need for a real wage decline in order to
restore equilibrium in high-unemployment economies. These arguments pro-
vide an important justification for traditional Keynesian policies, without rely-
ing on the standard assumptions of nominal wage or price rigidity.
A second major issue in macroeconomics that Larry has addressed is the
nature, and significance, of nominal wage and price rigidities. Larry, Julio
Rotemberg, and I [20] studied the evolution of wages, prices, and aggregate
output in the U.K. after a change in government in the early 1970s resulted in
a major shift from direct to indirect taxation. If nominal wages and prices are
178 Journal of EconomicPerspectives

fully flexible, then a revenue-neutral shift from wage to sales taxation should
have no real effects. In fact, we found that such a policy reduced output,
consistent with the presence of nominal rigidities. This finding supports neo-
Keynesian analyses of economic fluctuations.
In two subsequent papers, Larry examined the economic consequences of
price rigidities. DeLong and Summers [21] showed that even though price
rigidities can be an important source of economic fluctuations, reducing the
degree of price rigidity in an economy with some rigidity can actually destabilize
output. Their argument focuses on the potential for adverse aggregate demand
effects when increased price flexibility results in inflation, which in turn reduces
the real wealth of some households. A subsequent paper with Rotemberg [371
showed that nominal price rigidities, resulting for example from the need to set
prices before demand is known, can generate a procyclical pattern in productiv-
ity. The extent of procyclical productivity depends on the level of labor
hoarding and price rigidity in an industry, and the paper showed that cyclical
productivity patterns are more pronounced in those industries with lower labor
turnover.
A third strand of macroeconomic research, related to some of Larry's work
on capital income taxation, focuses on the determinants of household saving
behavior. While Larry was applying the multiperiod life-cycle model to analyz-
ing the interest elasticity of saving, he and Laurence Kotlikoff [5] embarked on
a project designed to evaluate the empirical relevance of this model. They
developed an elaborate algorithm for estimating the share of U.S. wealth that
could be attributed to life-cycle saving. They used age-earnings and age-
consumption profiles to build age-wealth profiles for individual households,
and also grossed up intergenerational transfers to obtain an upper bound for
the importance of life-cycle saving.
Their empirical findings suggested that life-cycle saving accounted for less
than half, and possibly much less than half, of accumulated household net
worth in the United States. These estimates, challenged by Franco Modigliani
(1988) and defended by Kotlikoff (1988), remain controversial. However, this
line of research has stimulated a substantial volume of subsequent research on
household saving behavior and particularly on the role of bequests in capital
accumulation.
Larry further explored the empirical validity of the life-cycle model in a
recent study with Christopher Carroll [39]. This study used household-level
surveys of income and expenditure to show that for most households, labor
income closely tracks consumption over the life cycle. This finding has been one
of several empirical regularities that have stimulated interest in alternatives to
the life-cycle model, such as models of precautionary saving or bequest-
motivated saving, as potential explanations for household saving decisions.
Larry's research on saving also includes one of his most colorful studies, a
joint paper with B. Douglas Bernheim and Shleifer [14] that developed and
tested a model in which individuals derive utility from bequests. As with many
 JamesM. Poterba 179

of Larry's research projects, this one began with a puzzle: why don't individuals
annuitize their wealth when they reach retirement, as the life-cycle model
suggests they should? The coauthors developed a model in which control over
wealth provides important utility benefits: individuals who control bequeath-
able wealth and who can disinherit heirs or charities receive more attention, or
other benefits, than those without such wealth.
The model alone is an important contribution to the literature on saving
behavior. But Bernheim, Shleifer, and Summers also tested one of its key
implications using data from the Retirement History Survey. They analyzed
survey questions on how frequently elderly individuals receive visits and tele-
phone calls from their children, and uncovered a strong correlation between
both measures of attention and an elderly household's bequeathable wealth.
They found no comparable correlation between attention and non-
bequeathable wealth. Both findings provide support for their model.
A final component of Larry's macroeconomic research that is concerned
primarily with the source of economic growth is his research program on
equipment investment and economic growth. DeLong and Summers [38] ana-
lyzed growth rates from a large cross section of nations and found that
countries that devote a high share of GDP to equipment investment tend to
grow faster, all else equal, than nations with a lower equipment-to-GDP share.5
Equipment investment appears to generate more economic growth than equal-
value structures investment. This result, which is consistent with the view that
equipment investment carries greater social externalities than investment in
structures, has important implications both for tax policy design and for
economic development strategy.

Mentor, Teacher, Friend

This paper describes many, but not all, of Larry's research contributions in
public finance, labor economics, financial economics, and macroeconomics. It
has not touched on his work in several other fields, including international
economics [34], economic demography [22], economic history [3], and develop-
ment economics [40]. Larry's influence on economic science, however, goes
beyond his contributions in particular subfields. He has promoted a particular
style of economic research, and leading by example, he has drawn a cohort of
young researchers into adopting, and extending, his approach to empirical
economics. As the Clark Medal citation put it, Larry's research "has inspired a

Larry's parents, Robert and Anita Summers, are both distinguished economists. This sometimes
causes confusion in research attribution. For example, DeLong and Summers [38] analyze the
widely used Summers-Heston data set, which was developed and described in detail by Robert
Summers and Alan Heston (1991). Moreover, while Larry has contributed much to public finance,
he should not be credited for Anita Summers and Barbara Wolfe's (1977) widely cited study on
production functions in public education.
180 Journal of Economic Perspectives

new generation of economists, many of them his students and collaborators,

who are now reconstructing the empirical foundations of the discipline."
What are the key elements of Larry's research style? First, his research is
directed at first-order economic issues, such as saving, unemployment, invest-
ment, and market efficiency. In one discussion of research strategy, Larry
remarked that "it's about as much work to write a paper on a big question as
on a little one, so you might as well pick a big one." Another favorite bit of
advice is to "be about the economy, not about the economics literature."
Larry's own research has followed these prescriptions.
Second, Larry's research is always directed at answering a question. Does
saving respond to after-tax interest rates? Is unemployment a transitory phe-
nomenon for most individuals? Are stock returns predictable? On many occa-
sions I have heard Larry advise doctoral students to avoid projects that are best
described as "a study of..." and to select instead projects that ask well-posed,
and answerable, questions. One of Larry's lasting contributions in many of the
fields described earlier is his concise identification of the key questions. Is
life-cycle saving empirically important? Do tests of market efficiency have any
statistical power? Were rising corporate tax burdens responsible for declining
real share prices in the 1970s? Even when his particular answers have been
challenged by other researchers, the questions that Larry identified, and the
frameworks he developed for answering them, have remained.
Third, Larry tries to marshall all of the available empirical evidence to
address particular questions. He is never satisfied with studying only the data in
the National Income and Product Accounts, or in widely used survey data sets.
Larry was in the vanguard of the recent movement in empirical economics that
has sought to identify exogenous shocks to various aspects of economic activity,
and to study the effects of these shocks as a way of learning about key economic
parameters. Many of Larry's research projects, such as the labor market effects
of World War II or the financial effects of the Texaco-Pennzoil bankruptcy,
illustrate this research strategy. This approach has been refined by many
subsequent researchers, and is closely related to the focus on "natural experi-
ments" that has become popular in labor economics, public finance, and other
applied fields in recent years.
Fourth, Larry's research style involves many simultaneous projects in
various stages of completion, and is often associated with vast amounts of data
analysis. This approach lends itself to involving a veritable army of research
assistants and collaborators. It also helps to identify robust empirical findings
and to suggest potential empirical puzzles, such as disparities between findings
in aggregate and household-level data, that demand further research.
Finally, Larry's conceptual approach to economics has evolved from a focus
on perfectly competitive models with fully informed, rational agents, to a
greater consideration of models and theories that embody market imperfec-
tions and incomplete rationality. His early research on life-cycle saving and
corporate investment relied heavily on rationality assumptions, while his later
 In Honor of LawrenceH. Summers 181

work on labor market hysteresis, failures of the life-cycle model, and "noise
traders," has moved away from these assumptions. This shift in part reflects
Larry's dissatisfaction with the empirical content of the assumption of agent
rationality in many contexts.
This paper has focused on Larry's research, but no description of his
contributions to economics would be complete without some discussion of his
role as an advisor, collaborator, and mentor. Although the "holding patterns"
outside his office doors at both MIT and Harvard were legendary among
graduate students, the predictable wait did not deter scores of students and
colleagues from seeking his advice.6 Larry's success as a mentor to undergradu-
ates, graduate students, and young researchers is extraordinary. The most
powerful evidence of his contribution to economic science is the popularity of
his research style amongst the younger cohort of empirical economists, many of
whom are proud to count themselves as Larry's students.

u I am grateful to Jeremy Bulow, Alan Krueger, Nancy Rose, Julio Rotemberg,Andrei

Shleifer, and TimothyTaylorfor encouragement,suggestions, and helpful commentson
an earlier drafi, and to the Centerfor Advanced Study in the Behavioral Sciences and
the National Science Foundationfor researchsupport.

6One former student recalls Larry walking out of his office, apologizing that their meeting would be
delayed by at least an hour, and then suggesting that "you could read some of my working papers
while you're waiting."
182 Journal of EconomicPerspectives
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