Conferences: Summer, 2007

China's Growing Role in World Trade

An NBER conference on "China's Growing Role in World Trade" took place in Chatham, MA on August 3 and 4. NBER Research Associates Robert C. Feenstra, who directs the Bureau's Program of Research on International Trade and Investment, and Shang-Jin Wei of NBER and Columbia University, who recently was on leave at the IMF, organized this meeting. The following papers were discussed:

• "The Rising Sophistication of China's Exports: Assessing the Roles of Processing Trade, Foreign Invested Firms, Human Capital and Government Policies"    Authors: Zhi Wang, International Trade Commission, and Shang-Jin Wei     Discussant: Galina Hale, Federal Reserve Bank of San Francisco
• "An Anatomy of China's Export Growth"    Authors: Mary Amiti, Federal Reserve Bank of New York, and Caroline Freund, IMF     Discussant: Bin Xu, China Europe International Business School
• "China's Local Comparative Advantage"   Authors: Haiyan Deng, The Conference Board, and James Harrigan,  Federal Reserve Bank of New York and NBER    Discussant: Chong Xiang, Purdue University
• "China and the Manufacturing Exports of Other Developing Countries"   Authors: Gordon H. Hanson, University of California, San Diego and NBER, and Raymond Robertson, Macalester College  Discussant: Irene Brambilla, Yale University and NBER
• "China's Exports and Employment"  Authors: Robert C. Feenstra, and Chang Hong, IMF  Discussant: Michael Dooley, University of California, Santa Cruz and NBER
• "Exporting Deflation? Chinese Exports and Japanese Prices"   Authors: Christian Broda, University of Chicago and NBER, and David E. Weinstein, Columbia University and NBER   Discussant: Joshua Aizenman, University of California, Santa Cruz and NBER
• "China's Current Account and Exchange Rate"   Authors: Yin-Wong Cheung, University of California, Santa Cruz; Menzie D. Chinn, University of Wisconsin and NBER; and Eiji Fujii, University of Tsukuba   Discussant: Jeffrey A. Frankel, Harvard University and NBER
• "China's WTO Entry: Antidumping, Safeguards, and Dispute Settlement"  Author: Chad P. Bown, Brandeis University Discussant: Thomas J. Prusa, Rutgers University and NBER
• "China's Experience Under the Multifiber Arrangement (MFA) and the Agreement on Textile and Clothing (ATC)" Authors: Irene Brambilla and Peter K. Schott, Yale University and NBER, and Amit Khandelwal, Yale University  Discussant: Joseph Francois, Johannes Kepler University Linz
• "Agricultural Trade Reform and Rural Prosperity: Lessons from China"  Authors: Jikun Huang and Yu Liu, Center for Chinese Agricultural Policy; Will Martin, World Bank; and Scott Rozelle, Stanford University  Discussant: Kym Anderson, University of Adelaide
• "Trade Growth, Production Fragmentation, and Chinas Environment"  Authors: Judith M. Dean, International Trade Commission, and Mary E. Lovely, Syracuse University   Discussant: Arik Levinson, Georgetown University and NBER
• "Facts and Fallacies about U.S. FDI in China"   Authors: Lee Branstetter, Carnegie Mellon University and NBER, and C. Fritz Foley, Harvard University and NBER   Discussant: Stephen Yeaple, University of Pennsylvania and NBER
• "Please Pass the Catch-up: The Relative Performance of Chinese and Foreign Firms in Chinese Exports, 1997-2005" Authors: Bruce A. Blonigen, University of Oregon and NBER, and Alyson C. Ma, University of San Diego Discussant: Raymond Robertson
• "China's Outward FDI: Past and Future"  Authors: Leonard K. Cheng, Hong Kong University of Science and Technology, and Zihui Ma, Renmin University of China   Discussant: Nicholas Lardy, Peterson Institute for International Economics

As China becomes a major world exporter, its product sophistication - measured by increased similarity between the product structure of its exports and those of the developed countries - has increased rapidly, as has the volume of its exports. This has generated anxiety in developed countries because the competitive pressure increasingly may be felt outside labor-intensive industries. Using product-level data on exports from different cities within China, Wang and Wei investigate the roles of processing trade, foreign invested firms, and government promotional policies – in the form of tax-favored high-tech development zones and export processing zones – in raising the country's export sophistication.

Decomposing China's real export growth, of over 500 percent since 1992, reveals a number of interesting findings. First, China's export structure changed dramatically, with growing export shares in electronics and machinery and a decline in agriculture and apparel. Second, despite the shift into these more sophisticated products, the skill content of China's manufacturing exports remained unchanged, once processing trade is excluded. Third, export growth was accompanied by increasing specialization and was accounted for mainly by high export growth of existing products (the intensive margin) rather than by new varieties (the extensive margin). Fourth, consistent with an increased world supply of existing varieties, Amiti and Freund find that China's export prices to the United States fell by an average of 1.6 percent per year between 1997 and 2005, while export prices of these products from the rest of the world to the United States increased by 0.7 percent annually over the same period.

China's trade pattern is influenced not just by its overall comparative advantage in labor intensive goods but also by geography. Deng and Harrigan show theoretically that, since trade costs are proportional to weight rather than value, relative distance affects local comparative advantage as well as the overall volume of trade. Their model predicts that China has a comparative advantage in heavy goods in nearby markets, and lighter goods in more distant markets. This theory motivates a simple empirical prediction: within a product, China's export unit values should be increasing in distance. Deng and Harrigan find some evidence for this effect in their empirical analysis on product-level Chinese exports in 2006, although the effect is small.

Hanson and Robertson examine the impact of China's growth on developing countries that specialize in manufacturing. Over 2000-5, manufacturing accounted for 32 percent of China's GDP and 89 percent of its merchandise exports, making it more specialized in the sector than any other large developing economy. Using the gravity model of trade, the authors decompose bilateral trade into the components associated with demand conditions in importing countries, supply conditions in exporting countries, and bilateral trade costs. They identify ten developing economies for which manufacturing represents more than 75 percent of merchandise exports (Hungary, Malaysia, Mexico, Pakistan, the Philippines, Poland, Romania, Sri Lanka, Thailand, and Turkey), all of which in theory are countries most exposed to the adverse consequences of China's export growth. The results suggest that if China's export supply capacity had been constant from 1996-2003, then the demand for exports would have been 0.6 percent to 1.4 percent higher in the ten countries studied. Thus, even for the developing countries most specialized in export manufacturing, China's expansion has represented only a modest negative shock.

Dooley et al (2003, 2004a,b,c) argue that China seeks to raise urban employment by 10-12 million persons per year because of export growth. In fact, total employment increased by 7.5 to 8 million per year over 1997-2005. Feenstra and Hong estimate that export growth over 1997-2002 contributed at most 2.5 million jobs per year, with most of the employment gains coming from non-traded goods like construction. Exports grew much faster over the 2000-5 period, which could explain in principal the entire increase in employment. However, the growth in domestic demand led to three-times more employment gains that did exports over 2000-5, while productivity growth subtracted the same amount from employment. The authors conclude that exports have become increasingly important in stimulating employment in China, but that the same gains could be obtained from growth in domestic demand, especially for tradable goods, which has been stagnant until at least 2002.

Broda and Weinstein highlight the importance of using the same methodology across price indexes when making economic comparisons between them. Using the CPI methodology, they find that the Import Price Index in Japan showed 20 percent inflation over 1992-2002 as opposed to the negative 9 percent inflation measured using the official import methodology. This undermines statements that suggest a very strong component of import prices on the overall CPI deflation in Japan. The authors also show that Japan's proximity to China has meant that Japanese trade patterns have changed dramatically over the past 15 years. The United States is no longer Japan's primary trading partner, as Japan trades far more with China than with the United States. Much of the growth in Chinese exports can be traced to rapid quality per unit price improvements. However, these very substantial changes in quality and expansion of China in new markets do not appear to have produced much of an impact on aggregate Japanese prices. In short, China does not seem to be exporting deflation to Japan.

Cheung, Chinn, and Fujii examine whether the Chinese exchange rate is misaligned and how Chinese trade flows respond to the exchange rate and to economic activity. They find first that the currency (CNY) is substantially below the value predicted by their cross-country estimates. The economic magnitude of the mis-alignment is substantial -- on the order of 50 percent in log terms. However, the misalignment is typically not statistically significant, in the sense of being more than two standard errors away from the conditional mean. Next, they find that Chinese multilateral trade flows respond to relative prices -- as represented by a trade weighted exchange rate -- but that that relationship is not always precisely estimated. In addition, the direction of the effects is sometimes different from what is expected a priori. For instance, Chinese ordinary imports actually rise in response to a yuan depreciation; however, Chinese exports appear to respond to yuan depreciation in the expected manner, as long as a supply variable is included. In that sense, Chinese trade is not exceptional. Furthermore, Chinese trade with the United States appears to behave in a standard manner -- especially after the expansion in the Chinese manufacturing capital stock is accounted for. Thus, the China-U.S. trade balance should respond to real exchange rate and relative income movements in the anticipated manner. However, in neither the case of multilateral nor bilateral trade flows should one expect quantitatively large effects arising from exchange rate changes. And, of course, these results are not informative with regard to the question of how a change in the CNY/USD exchange rate would affect the overall U.S. trade deficit. Finally, the authors highlight the fact that considerable uncertainty surrounds both their estimates of CNY misalignment and the responsiveness of trade flows to movements in exchange rates and output levels. In particular, the results for trade elasticities are sensitive to econometric specification, accounting for supply effects, and for the inclusion of time trends.

Bown assesses China's integration into the global trading system by examining areas of international political-economic "friction" associated with its increased trade. He uses a number of newly constructed datasets to examine the tensions associated with China's rapidly increasing trade and the trade policy commitments that it and its trading partners have undertaken as part of its 2001 WTO accession. Examining data on WTO members' use of antidumping, and their discriminatory treatment of Chinese firms prior to and following accession, he concludes that the application of antidumping against China has become more discriminatory since 2001. Furthermore, regression evidence rules out the theory that pre-accession discrimination is associated with foreign targeting of high import-tariff Chinese products as a WTO accession negotiation strategy. Bown also shows that WTO members are discriminating against China's exports by substituting the use of new import-restricting "China-safeguard" policy instruments. He goes on to examine data on China's antidumping use – it is now the WTO's fifth most frequent user of antidumping – by targeted sectors and countries. He also provides evidence of a positive relationship between the size of the accession-year tariff liberalization and the subsequent resort to antidumping protection after accession. Finally, he examines China's experience in managing frictions associated with its growing role in world trade through formal WTO dispute settlement proceedings.

Brambilla, Khandelwal, and Schott analyze China's experience under U.S. apparel and textile quotas. They use a unique new database that tracks U.S. trading partners' performance under the quota regimes established by the global Multifiber Arrangement (1974 to 1995) and subsequent Agreement on Textiles and Clothing (1995 to 2005). They find that China was relatively more constrained under these regimes than other countries and that, as quotas were lifted, China's exports grew disproportionately.

Tariffs on agricultural products fell sharply in China both prior to, and as a consequence of, China's accession to the WTO. Huang and his co-authors examine the nature of agricultural trade reform in China since 1981, and find that protection was quite strongly negative for most commodities, particularly for exported goods, at the beginning of the reforms. Since then, the taxation of agriculture has declined sharply, with the abolition of production quotas and procurement pricing, and reductions in trade distortions for both imported and exported goods. Rural well-being has improved, partly because of these reforms, and because of strengthening of markets, public investment in infrastructure, research and development, health and education, and reductions in barriers to mobility of labor out of agriculture. Much remains to be done to improve rural incomes and reduce rural poverty.

Using official Chinese environmental data on air and water pollution from the State Environmental Protection Agency and highly disaggregated trade data from China Customs, Dean and Lovely present evidence that the pollution intensity of Chinese exports fell dramatically between 1995 and 2004. They then explore the possibility that trade fragmentation and foreign investment have played a role. Using the framework provided by Copeland and Taylor (1994, 2003), they develop a reduced-form model of the pollution intensity of trade, incorporating standard determinants of a country's production mix, such as factor proportions, income per capita, and trade policy. They explicitly incorporate the degree to which Chinese exports are fragmented, building on the work of Feenstra and Hanson (1996). They then use this model to test the effect of increased fragmentation on the time trends they observe in the pollution intensity of trade. The evidence supports the view that increased foreign investment and production fragmentation have contributed positively to the decline in the pollution intensity of China's trade, as has accession to the WTO. Growth in China's per capita real income is also associated with the trend toward cleaner trade.

Despite the rapid expansion of U.S.-China trade ties, the increase in U.S. FDI in China, and the expanding amount of economic research exploring these developments, a number of misconceptions distort the popular understanding of U.S. multinationals in China. Branstetter and Foley seek to correct four common misunderstandings by providing a statistical portrait of several aspects of U.S. affiliate activity in the country and placing this activity in its appropriate economic context.

Foreign-invested enterprises (FIEs) account for well over half of all Chinese exports and this share continues to grow. While the substantial presence of FIEs has contributed greatly to the recent export-led growth of China, an important objective of the Chinese government is to ultimately obtain foreign technologies and develop their own technological capabilities domestically. Blonigen and Ma use detailed data on Chinese exports by sector and type of enterprise to examine the extent to which domestic enterprises are "keeping up" or even "catching up" to FIEs in the volume, composition and quality of their exports. They also use a newly-created dataset on Chinese policies encouraging or restricting FIEs across sectors to examine the extent to which such policies can affect the evolving composition of Chinese exports.

Cheng and Ma provide a systematic analysis of the size and composition of China's outward FDI in 2003-5. Despite the attention given to China's recent outward FDI and the prospect that it will continue to surge upward, its investment flows and stocks were smaller than those of some small industrial economies and some emerging developing economies as of 2005. The bulk of China's FDI was made up of firms owned by or associated with different levels of governments, including its largest multinational companies. By the end of 2005, business services accounted for the largest share of China's outward FDI stock (28.9 percent), followed by wholesale and retail, mining and petroleum, transportation and storage, and manufacturing. The true breakdown of the destination of China's FDI was basically unknown because a predominant share of its FDI in recently years was done in the world's tax havens. The empirical analysis reveals that the host economies' GDP had a positive impact, whereas their respective distances from China had a negative impact, on attracting FDI from China. Their per capita GDP had no impact on FDI flows but had a negative impact on FDI stocks. Cultural proximity was a positive factor in attracting China's FDI to the host economies that speak the Chinese language. China's future FDI outflows based on its own past experience, international experience, and Japan and South Korea's experience with FDI outflows are forecast; the baseline forecasts based on the experience of many FDI source economies indicate that China's aggregate FDI outflow will reach US$20 billion around 2008, US$30 billion in the early 2010s, and US$50 billion by 2015. In more optimistic forecasts based on the experience of Japan and South Korea, the first two thresholds will be reached one year earlier and the third threshold will be reached five years earlier.

These conference proceedings will be published by the University of Chicago Press in an NBER Conference Volume. Its availability will be announced in the NBER Reporter. The papers are also available at "Books in Progress" on the NBER's website.

Twentieth Anniversary Tokyo Conference

The NBER, TCER (Tokyo Center for Economic Research), and CEPR (Centre for Economic Policy Research, in London) jointly sponsored a twentieth anniversary conference on financial globalization in Tokyo on September 4 and 5. Organizers Takeo Hoshi of the University of California, San Diego and NBER, and Takatoshi Ito, of the University of Tokyo, TCER, CEPR, and NBER, chose these papers for discussion:

• Nicolas Coeurdacier and Philippe Martin, University of Paris I and CEPR, "The Geography of Asset Trade and the Euro: Insiders and Outsiders"  Discussant: Ryuzo Miyao, Kobe University and TCER
• Mark M. Spiegel, Federal Reserve Bank of San Francisco, "Monetary and Financial Integration: Evidence from the EMU"  Discussant: Linda Goldberg, Federal Reserve Bank of New York and NBER
• Barry Eichengreen, University of California, Berkeley, CEPR, and NBER, and Sudarat Ananchotikul, University of California, Berkeley, "Corporate Governance Reform in Emerging Markets: How Much, Why, and with What Effects?" Discussant: Takeo Hoshi
• Philip R. Lane, Trinity College Dublin and CEPR, and Gian Maria Milesi-Ferretti, IMF and CEPR, "Where Did All the Borrowing Go? A Forensic Analysis of the U.S. External Position" Discussant: Shinji Takagi, Osaka University and TCER
• Sebastian Edwards, University of California, Los Angeles and NBER, " Financial Globalization, Sequencing of Reforms, and Macroeconomic Vulnerability: A Latin American View"  Discussant: Masahiro Kawai, ADBI and TCER
• Koichi Hamada, Yale University, and Yasushi Okada, ESRI, "Two Decades after the Plaza Accord: A Package of Mixed Blessings" Discussant: Mitsuhiro Fukao, Keio University and TCER
• Toshitaka Sekine, Bank of Japan and TCER, "Another Look at Global Disinflation" Discussant: Tsutomu Watanabe, Hitotsubashi University and TCER

Coeurdacier and Martin analyze the determinants of cross-border asset trade using cross-country data and a Swedish dataset. They focus on the impact of the euro for the determinants of trade in bonds, equity, and banking assets. With the help of a theoretical model, they disentangle the different effects that the euro may have on cross-border asset holdings for both euro zone countries and countries outside of the euro zone. They find that the euro implies a unilateral financial liberalization, which makes it cheaper for all countries to buy euro zone assets. For bonds and equity holdings, this translates into approximately 14 percent and 17 percent lower transaction costs. Using the Swedish data, they find that this effect of the euro is larger for flows than for stocks. Also, there is a preferential financial liberalization, which on top of the previous effect lowers transaction costs inside the euro zone by approximately 17 percent and 10 percent for bonds and equity respectively. Third, a diversion effect exists because of the fact that lower transaction costs inside the euro zone entail euro countries to purchase less equity from outside the euro zone. The empirical analysis also suggests that the elasticity of substitution between bonds inside the euro zone is three times higher than between bonds denominated in different currencies.

Spiegel examines the impact of European Monetary Union (EMU) accession on bilateral international commercial bank lending patterns. Using a difference-in-differences methodology, he demonstrates that accession to the EMU was accompanied by a change in Portuguese and Greek borrowing in favor of borrowing from their EMU partner nations. This extends the evidence in the literature that overall international borrowing is facilitated by the creation of a monetary union, and raises the possibility of financial diversion.

In the ten years since the Asian crisis, considerable progress has been made in strengthening the financial infrastructure in emerging markets. Still, some observers are critical that progress has not been faster.Eichengreen and his co-author consider why – and with what effects – using corporate governance reform as a case study Their results confirm that corporate governance improves with economic development. But, in addition, they point to specific circumstances that appear to facilitate the development of strong corporate governance practice. Corporate governance appears to improve with the stability and development of the political system, as if governments that expect to remain in power are readier to sink the costs of reforms that only pay off down the road, and that investors are better able to effectively communicate their interest in corporate governance reform in countries with well-developed political systems. There is also some evidence that countries where foreign investors are more prominent push for improvements in corporate governance. Finally, there is some evidence that corporate governance is stronger in countries with a common law tradition, where shareholders are likely to be more active and better able to represent their interests. Using these same political variables as instruments for corporate governance, the results suggest that corporate governance quality has a positive impact on private bond market capitalization, stock market capitalization, the number of listed companies, and the turnover ratio on the stock market – but not, plausibly, for public bond market capitalization. The results thus support the notion that corporate governance reform can make a difference for financial development.

The deterioration in the U.S. net external position in recent years has been much smaller than the extensive net borrowing associated with large current account deficits would have suggested. Lane and his co-author examine the sources of discrepancies between net borrowing and accumulation of net liabilities for the U.S. economy over the past 25 years. In particular, they highlight and quantify the role played by net capital gains on the U.S. external portfolio and "residual adjustments" in explaining this discrepancy. Finally, they discuss whether these residual adjustments are likely to be originating from measurement errors in external assets and liabilities, financial flows, or capital gains, and explore the implications of these conjectures for the U.S. financial account and external position.

Edwards uses a large cross-country dataset and panel probit analysis to investigate whether an increase in the degree of openness – both financial openness and trade openness – affects the probability of external crises. Although the analysis is motivated by Latin America's experiences, the dataset covers countries from every region in the world. He is particularly interested in investigating the way in which the interaction between trade and financial openness affect these probabilities. He also focuses on current account and fiscal imbalances, contagion, international reserves holdings, and the exchange rate regime as possible determinants of external crises. The results indicate that relaxing capital controls increases the likelihood of a country experiencing a sudden stop. Moreover, the results suggest that "financial liberalization first" strategies increase the degree of vulnerability to external crises. This is particularly the case if this strategy is pursued with pegged exchange rates and it results in large current account imbalances.

The Plaza Accord in 1985, and a series of subsequent attempts by major industrial countries to coordinate exchange rates, marked a dramatic era in the history of interventions into exchange rate markets under flexible exchange rates. The good news was that, at least at the beginning, it succeeded in changing the direction of exchange rates and apparently in moderating the current account imbalances of major participants, like Japan and United States. The bad news was that it could not stop real exchange rates from tumbling too far in an extreme direction. In their paper, Hamada and Okada first demonstrate theoretically that under a floating regime the benefit from exchange rate coordination is very limited, and that joint attempts at coordination in fact imposed on the advanced economies an unnecessary, additional constraint to maintain their current account balances. Then the authors trace the effects of exchange rate coordination on the macroeconomic performance of the Japanese economy. The react to the contraction attributable to the higher yen after the Plaza Accord was a combination of expansionary monetary and fiscal policies, and this reaction continued too long. When the Bank of Japan undertook corrective measures to curb asset bubbles, it adopted a precipitous contraction of the money supply, which most probably was one of the main reasons for massive asset deflation. This paper presents a macroeconomic overview of how the Japanese economy was exposed to the fluctuation of the yen real exchange rate and how it finally recovered from its heavy burden of overvaluation of the exchange rate.

Sekine highlights the relative price adjustments that were taking place in the global economy as one important source of the lower level of inflation rates observed in recent decades. Using a markup model, he shows that substantial effects come from declines in wage costs and import prices relative to consumer prices. Out of a 5-percentage-point decline in the inflation rates in eight OECD countries betweem 1970-89 and 1990-2006, Sekine says that more than 1.5 percentage points can be explained by global shocks to these two relative prices, while monetary policy shocks account for another one percentage point.

It is anticipated that these papers will be published in the Journal of the Japanese and International Economies.

Entrepreneurship: Strategy and Structure

An NBER Conference on "Entrepreneurship: Strategy and Structure," organized by Thomas Hellmann, University of British Columbia, and Scott Stern, NBER and Northwestern University, took place on September 14 and 15. The agenda for the meeting was:

• Hongbin Cai, University of California, Los Angeles; Yasuyuki Todo, University of Tokyo; and Li-An Zhou, Peking University, "Impacts of Multinational Enterprises on Indigenous Entrepreneurship and Innovation: Evidence from a Chinese Science Park" Discussant: Rebecca Henderson, MIT and NBER
• Anand Nandkumar and Ashish Arora, Carnegie Mellon University, "Entry, Commercialization Strategies, and Performance: The Case of the Information Security Industry" Discussant: Jean De Bettignies, Queen's University
• Joshua S. Gans, University of Melbourne, "Start-Up Commercialization Strategy and Innovative Dynamics" Discussant: Yael Hochberg, Northwestern University
• Boris Groysberg, Ashish Nanda, and M. Julia Prats, Harvard University, "Does Individual Performance Affect Entrepreneurial Mobility? Empirical Evidence from the Financial Analysis Market" Discussant: Ajay Agrawal, University of Toronto and NBER
• Vladimir Atanasov, The College of William and Mary; Vladimir Ivanov, University of Kansas; and Kate Litvak, University of Texas at Austin, "The Impact of Litigation on Venture Capitalist Reputation" Discussant: Ramana Nanda, Harvard University
• Panel on "The Strategy and Structure of Entrepreneurship": Timothy Bresnahan, Stanford University and NBER; Ben Jones, Northwestern University and NBER; and Josh Lerner, Harvard University and NBER
• Marco Da Rin and Maria Fabiana Penas, Tilburg University, "The Effect of Venture Capital on Innovation Strategies" Discussant: David Hsu, University of Pennsylvania
• Iain M. Cockburn and Megan J. MacGarvie, Boston University and NBER, "Patents, Thickets and Early Stage Firms: Evidence from the Software Industry" Discussant: William Kerr, Harvard University
• Andres Almazan and Sheridan Titman, University of Texas at Austin; and Javier Suarez, CEMFI, "Firms' Stakeholders and the Costs of Transparency" Discussant: Kose John, New York University
• Timothy Simcoe, University of Toronto; Maryann Feldman, University of Georgia; and Stuart Graham, Georgia Institute of Technology, "Competing on Standards? Entrepreneurship, Intellectual Property, and the Platform Paradox" Discussant: Shane Greenstein, Northwestern University and NBER

Using a unique firm-level dataset from China's "Silicon Valley," Cai and his co-authors investigate how multinational enterprises (MNEs) affect local entrepreneurship and R and D activities upon entry. They find that R and D activities of MNEs in an industry stimulate entry of domestic firms into the same industry and enhance R and D activities of newly entering domestic firms. By contrast, MNEs' production activities, or domestic firms' R and D activities, do not have such an effect. Since MNEs are technologically more advanced than domestic firms, these findings are consistent with a knowledge diffusion hypothesis: that diffusion of MNEs' advanced knowledge to potential indigenous entrepreneurs through MNEs' R and D stimulates entry of domestic firms.

Nandkumar and Arora study how the existence of a functioning market for technology conditions the entry strategy of different types of entrants, and the relative advantage of incumbent firms as compared to startups. The researchers find that markets for technology both facilitate entry of firms that lack proprietary technology and increase vertical specialization. However, these markets also increase the relative advantage of downstream capabilities, which is reflected in the relatively improved performance of incumbent firms as compared to startups. Moreover, the authors find that firms founded by serious hobbyists and tinkerers, whom they call hackers, perform markedly better than other startups. This perhaps reflects the non-manufacturing setting of this study, as well as the distinctive nature of software technology.

Gans endogenizes a start-up's choice between competitive and cooperative commercialization in a dynamic environment. He demonstrates that, depending upon firms' dynamic capabilities, there may or may not be gains to trade between incumbents and start-ups in a cumulative innovation environment; that is, start-ups may not be adequately compensated for losses in future innovative potential. Because of this, there is no clear relationship between observed inter-industry innovation and commercialization choice, unless dynamic capabilities of firms are taken into account. In addition, the analysis demonstrates subtle and novel insights into the relationship between dynamic capabilities and rates of innovation.

Groysberg and his co-authors' analysis relies on a panel dataset of research analysts in investment banks over 1988-96 and reveals that star analysts are more likely than non-star analysts to become entrepreneurs. Furthermore, the researchers find that ventures started by star analysts have a higher probability of survival than ventures established by non-star analysts. Extending traditional theories of entrepreneurship and labor mobility, their results also suggest that drivers of turnover vary by destination: that is, turnover to entrepreneurship versus other turnover. In contrast to turnover to entrepreneurship, star analysts are less likely to move to other firms than non-star analysts.

Venture capital(VC) contracts give VCs enormous power over entrepreneurs and early equity investors of portfolio companies. A large literature examines how these contractual terms protect VCs against misbehavior by entrepreneurs. But what constrains misbehavior by VCs? Atanasov and his co-authors provide the first systematic analysis of legal and non-legal mechanisms that penalize VC misbehavior, even when such misbehavior is permitted by the contract. They hand-collect a sample of over 177 lawsuits involving venture capitalists. The three most common types of VC-related litigation are: 1) lawsuits filed by entrepreneurs, which most often allege freezeout and transfer of control away from founders; 2) lawsuits filed by early equity investors in startup companies; and 3) lawsuits filed by VCs. The researchers first estimate an empirical model of the propensity of VCs to get involved in litigation as a function of VC characteristics. Then they match each venture firm that was involved in litigation t an otherwise similar venture firm that was not involved in litigation. They find that less reputable VCs are more likely to participate in litigation, as are VCs focusing on early-stage investments and VCs with larger deal flow. More reputable VCs are more likely to get involved in lawsuits involving control transfers and freeze-outs, but not dilution and asset transfers. Suits against more reputable VCs usually involve allegations of more severe misconduct (direct expropriation of founders rather than, for example, securities class action). Next the authors analyze the relationship between different types of lawsuits and VC fundraising and deal flow. Although plaintiffs lose most VC-related lawsuits, litigation does not go unnoticed: in subsequent years, the involved VCs raise significantly less capital than their peers and invest in fewer deals. The biggest losers are VCs who were defendants in a lawsuit and lost, and especially VCs who were alleged to have expropriated founders. The researchers find no strong relationship between litigation and the quality of future deals.

Da Rin and Fabiana Penas examine a unique dataset of Dutch companies, some of whom have received venture financing. The dataset contains details about companies' innovation strategies. The authors find that companies backed by venture capitalists develop more assertive innnovation strategies, based on protection of intellectual property (IP) rights, on the creation of strong "absorptive capacity", and on in-house skills. The researchers also document that venture backed companies do not seem to increase their level of innovation cooperation with third parties.

The impact of stronger intellectual property rights in the software industry is controversial. One means by which patents can affect technical change, industry dynamics, and ultimately welfare, is through their role in stimulating or stifling entry by new ventures. Patents can block entry, or raise entrants' costs in variety of ways, while at the same time they may stimulate entry by improving the bargaining position of entrants vis-à-vis incumbents, and supporting a "market for technology" that enables new ventures to license their way into the market, or realize value through trade in their intangible assets. Much of the impact of these effects may work through the capital markets, and Cockburn and MacGarvie find evidence that the extraordinary growth in patenting of software has had a significant impact on the financing of software companies. Start-up software companies operating in markets characterized by denser patent thickets see their initial acquisition of VC funding delayed relative to fi in markets less affected by patents. Once funding is acquired, firms that eventually go public or are acquired take longer to do so for a given amount of investment. And, firms in "thicketed" markets are less likely to go public. However, these effects are mitigated for firms that themselves are able to obtain patents: these ventures acquired funding earlier and were more likely generate a "liquidity event" for early stage investors by going public.

Almazan and his co-authors develop a model of a firm whose production process requires it to start and nurture a relationship with its stakeholders. Because there are spillover benefits associated with being associated with a "winner," the perceptions of its stakeholders and potential stakeholders can be key to the firm's success. This analysis indicates that while transparency (that is, disseminating information about a firm's quality) may improve the allocation of resources, a firm may have a higher ex ante value if information about its quality is not prematurely revealed. The costs associated with transparency arise in this model when some, but not all, stakeholders of a firm benefit from having a relationship with a high quality firm, and these costs are higher when firms can initiate non-contractible innovative investments that enhance the value of their stakeholder relationships. Stakeholder effects of transparency are especially important for younger firms with less established track record (for example, start-ups).

Simcoe and his co-authors examine the strategic choices of entrepreneurial firms that contribute innovation to technology platforms in standard setting organizations (SSOs). Entrepreneurs, lacking complementary assets, have incentives to aggressively pursue their intellectual property rights. Using data on patents disclosed at 14 SSOs over a 25-year period, the researchers examine the litigation of disclosed patents as well as firm-level trends in disclosure. The evidence suggests that enterpreneurs who disclose patents pursue a more aggressive IP strategy than their larger more vertically integrated counterparts. Patents assigned to entrepreneurial firms are 6 percentage points more likely to be litigated than those assigned to large public compaines. Small firms appear more likely to ligitate after patents are disclosed to an SSO.

These papers will be published in a special issue of the Journal of Economics and Management Strategy. They are also available at "Books in Progress" on the NBER's website.

Tax Policy and the Economy

The NBER's Twenty-second Annual Conference on Tax Policy and the Economy, organized by James M. Poterba of NBER and MIT, took place in Washington, DC on September 27. These papers were discussed:

• Stephen T. Parente and Roger Feldman, University of Minnesota,"Do HSA Choices Interact with Retirement Savings Decisions?"
• Susan M. Dynarski, Harvard University and NBER, and Judith E. Scott-Clayton, Harvard University, "Weighing the Costs and Benefits of Complexity in Student Aid"
• Gene Amromin, Federal Reserve Bank of Chicago, "Precautionary Savings Motives and the Tax Efficiency of Household Portfolios: An Empirical Analysis"
• James M. Poterba; Steven Venti, Dartmouth College and NBER; and David A. Wise, Harvard University and NBER, "New Estimates of the Future Path of 401(k) Assets"
• Charles E. McLure,Jr., Stanford University and NBER, "Harmonizing Corporate Income Taxes in the European Community: Rationale and Implications"

Parente and Feldman collected data on employees' health plan choices and retirement savings decisions from a large employer with a nearly 16,000-person workforce that offered traditional health plans and a health savings accounts (HSAs) in 2006. The researchers also recorded employees' retirement contributions for the current and prior years along with their health plan choices. They examined first whether employees make joint choices about a traditional health plan versus an HSA and participation in an optional retirement plan, and second, conditional on participation, the amount of the employee's contribution to the optional plan. Using health insurance claims and other human resources data to create control variables of income, job type, age, gender, number of dependents, and health status of the household, the authors find that those who elected an HSA were more likely to participate in a retirement savings account, and once invested, that HSA policyholders may be more likely to supplement retirement assets.

A growing body of empirical evidence shows that financial aid can increase college enrollments. Puzzlingly, there is little compelling evidence of the effectiveness of Pell Grants and Stafford Loans, the primary federal student aid programs. Complexity and uncertainty in the aid system may be the culprit. The perspectives of classical and behavioral economics suggest that complexity in the aid system at the very least imposes substantial transaction costs and at worst discourages the target population from applying for student aid. While the bounds on the costs of complexity are wide, Dynarski and Scott-Clayton show that its benefits are miniscule. Detailed data from federal student aid applications show that a radically simplified aid process can reproduce the current distribution of aid using a fraction of the information now collected.

Theoretical portfolio models with taxable and tax-deferred savings require savers to locate higher-tax assets such as bonds in their tax-deferred retirement accounts (TDAs) while keeping low-tax assets (equities) in taxable accounts. Yet, observed portfolio allocations are often not tax-efficient. Amromin empirically evaluates one of the explanations for this puzzle that rests on the simultaneous presence of uninsurable labor income risk and limited accessibility of TDA assets. Together, these elements lead some borrowing-constrained households to forgo tax-efficiency in favor of allocations that provide more liquidity in bad income states – an outcome labeled as "precautionary portfolio choice." The analysis of household-level portfolio data from the Survey of Consumer Finances suggests that both the choice of whether to hold a tax-efficient portfolio and the degree of portfolio tax-inefficiency are related to the presence and severity of precautionary motives.

The future paths of 401(k) contributions and withdrawals, and the associated path of asset accumulation, affect federal income tax revenues and the preparation of future retirees for their retirement years. Over the past two and a half decades there has been a fundamental change in saving for retirement in the United States, with a rapid shift from employer-managed defined benefit pensions to defined contribution saving plans that are largely controlled by employees. In this paper, Poterba, Venti, and Wise project the future growth of assets in self-directed personal retirement plans at age 65 for cohorts attaining age 65 between now and 2040. They also project the ratio of 401(k) assets at age 65 to prior earnings, and the ratio of 401(k) account balances to GDP. Their projections suggest that cohorts that attain age 65 in future decades will have accumulated more retirement saving (in real dollars) than current retirement-age cohorts.

The Member States of the European Community have systems of taxing corporate income that are more appropriate for nations than for members of an economic union. McLure describes the problems of the present system, which is based on separate accounting and arm's length pricing, the advantages of one based on consolidation and formula apportionment, such as those employed by the U.S. states and Canadian provinces, the likely characteristics of such a system, and the complications caused by income flows to and from the EC, and the implications of harmonization, for both EC Member States and non-EC nations and for multinational corporations. It seems virtually certain that a harmonized EC system (like that of Canada) would exhibit far more uniformity than state corporate income taxes in the United States and, like some state taxes (but unlike the Canadian system), would involve consolidation of the activities of corporations characterized by high levels of common ownership and control. Finally, McLure speculates on the prospects for harmonization, given a) that adoption of tax measures applicable to all Member States requires the unanimous approval of all EC Member States, but b) as few as eight Member States could harmonize their taxes, through "enhanced cooperation."

These papers will be published by the MIT Press as Tax Policy and the Economy, Volume 22. They are also available at "Books in Progress" on the NBER's website.