Technology and the Cost of Equity Capital

George N. Hatsopoulos

In 1985, when the U.S. trade deficit reached an unprecedented 3 percent of U.S. gross national product and Japanese trade surpluses reached an equally unprecedented 4 percent of Japan's gross national product, economists argued that the principal cause of the problem was the abnormally high exchange rate of the dollar at 260 yen. Many economists contended that our trade balance would be restored simply by reducing the exchange rate to about 170 yen per dollar. At about the same time, our business leaders were addressing the trade issue in their own way. In their view, U.S. manufacturers could not be competitive when Japanese wages were only about half those prevailing here.

Five years later, with the value of the dollar now reduced by almost a factor of two and with Japanese wages having reached parity with our own, the U.S. trade deficit persists. The level is somewhat reduced, but, most significantly, Japanese surpluses continue unabated. Today few people doubt that U.S. industrial competitiveness is declining; there is, however, as yet, no consensus on the causes of such decline. Nevertheless, a central issue seems to attract growing attention: the shortsightedness of U.S. corporate management. This issue, which has been discussed in academic circles for some time, attained national focus in early 1987 as the result of a speech by Richard Darman, then deputy secretary of the treasury. Further support for this position was given by the Massachusetts Institute of Technology report on industrial competitiveness, Made in America (Dertouzos et al., 1989).

The MIT study presents ample evidence of American management's preoccupation with short-term profits and its lack of commitment to long-term competitiveness. This is not news to most Americans.



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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering Technology and the Cost of Equity Capital George N. Hatsopoulos In 1985, when the U.S. trade deficit reached an unprecedented 3 percent of U.S. gross national product and Japanese trade surpluses reached an equally unprecedented 4 percent of Japan's gross national product, economists argued that the principal cause of the problem was the abnormally high exchange rate of the dollar at 260 yen. Many economists contended that our trade balance would be restored simply by reducing the exchange rate to about 170 yen per dollar. At about the same time, our business leaders were addressing the trade issue in their own way. In their view, U.S. manufacturers could not be competitive when Japanese wages were only about half those prevailing here. Five years later, with the value of the dollar now reduced by almost a factor of two and with Japanese wages having reached parity with our own, the U.S. trade deficit persists. The level is somewhat reduced, but, most significantly, Japanese surpluses continue unabated. Today few people doubt that U.S. industrial competitiveness is declining; there is, however, as yet, no consensus on the causes of such decline. Nevertheless, a central issue seems to attract growing attention: the shortsightedness of U.S. corporate management. This issue, which has been discussed in academic circles for some time, attained national focus in early 1987 as the result of a speech by Richard Darman, then deputy secretary of the treasury. Further support for this position was given by the Massachusetts Institute of Technology report on industrial competitiveness, Made in America (Dertouzos et al., 1989). The MIT study presents ample evidence of American management's preoccupation with short-term profits and its lack of commitment to long-term competitiveness. This is not news to most Americans.

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering Consumers long have been aware of declining quality of U.S.-made products compared with imports. Moreover, there is growing awareness that foreign competitors, particularly the Japanese, are more willing to forgo current profits to increase market share in virtually any manufacturing enterprise. National data on industrial investment in research and development corroborate these perceptions. From 1986 to 1989, spending for research and development by U.S. corporations declined as a share of gross national product. In fact, total research and development spending, adjusted for inflation, actually declined in 1989. We see a lot of technology being developed in this country, ranging from basic technology to practical inventions. Yet, America incorporates its innovation and technology into internationally marketed products and services at a rate that is scandalously below its true potential. Japan appropriates and commercializes American technology at a much higher rate than we do. The thesis presented in this paper is that the overriding factor affecting the ability of an industry to incorporate technology into products is the rate of return on equity capital demanded by stockholders. The average price-to-earnings ratio for corporations listed on the New York Stock Exchange is currently about 14. The corresponding figure for the Tokyo Stock Exchange, corrected for accounting differences, is roughly 40. This means that a U.S. corporate manager must ensure that for every $100 of equity investment, the annual return will be at least $7. In Japan, the corresponding figure is $2.50. It also means that any equity-financed investment that promises to double in value within 12 years would be considered an irresponsible act in the United States, but worthy of praise in Japan. Small wonder that Japanese managers take a longer view! The differing economic environments that drive both investment decisions and planning horizons in various countries can be described by a variable known as the cost of capital. In the following discussion, we shall examine what cost of capital means, what it affects, and what it is affected by. Recent estimates of the cost of capital in the United States and Japan also are presented. THE COST OF CAPITAL In an ideal world, free of both taxes and risks, corporations could finance any and all projects through borrowing, provided that those projects were sure to return more than the interest rate demanded by lenders. In such a world, the cost of capital would be the interest

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering rate. Moreover, if competition were "perfect," the return on all projects would be the same, and it would be identical to the cost of capital. In the real world, of course, things are quite different. Taxes have to be paid under rather complicated rules, and predictions cannot be made with certainty. Therefore, all projects involve risks, and those risks represent a significant burden to prospective investors. At some price, lenders are willing to bear a certain level of risk. In practice, most of that risk is borne by holders of equity. In the imperfect world, equity holders are represented by corporate managers whose fiduciary obligation is to provide, as best as they can, the return required by these holders. It follows that corporate managers should invest only in those projects that promise to return a pretax profit sufficient to provide the taxes required by law, the interest required by lenders, and dividends and capital gains required by equity holders. The real net cost of capital, or simply the cost of capital, for an investment is the least return that satisfies all of the requirements cited above. Its magnitude depends on many factors, including tax rates. As a result, the cost of capital for a given type of investment by a corporation may differ from that of an individual, simply because corporations are taxed at different rates than individuals. The cost of capital that is important to the international competitiveness of nations, however, is that which pertains to corporations, because most international trade is done by corporations. The cost of capital provides a criterion for investments in new projects. Actual returns on past investments may differ from the current cost of capital as a result of changes in the economic environs. It can even differ from that prevailing at the time those investments were made, since unforeseen events may have raised or lowered the return on past projects. A general expression for corporate cost of capital is given in Hatsopoulos and Brooks (1985). Its derivation is based on the approach developed by Hall and Jorgenson (1967). The expression contains several variables, principally the real after-tax cost of funds described below, the depreciation rate of the investment, and several elements of the tax code. In making investments, corporations use two sources of funds—equity and debt. Each source differs in its exposure to risk, its taxation, and its cost. The use of equity exposes a corporation to the least risk, because it involves no fixed obligation to provide either returns or repayments. For the same reason, the supplier of equity funds is exposed to the biggest risk. Use of interest-bearing debt exposes a corporation to

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering the biggest risk, and the supplier of funds to the least, because it involves a fixed obligation to provide returns and to repay the funds. The two sources of funds impose different corporate tax burdens on the return to holders. Payments to equity holders are taxed, whereas payments to debt holders are not. The real after-tax cost of funds is the average of the real after-tax cost of debt and the real cost of equity. These are weighted in proportion to the relative amounts of debt and equity used by the corporation to finance a given investment. The real after-tax cost of debt, Cd, is related to the interest rate, i, which the corporation must pay to lenders. This rate is adjusted for inflation and for the tax deduction on interest payments provided by the tax code. The adjustments yield the following expressions for Cd: where τ is the tax rate on corporate income and π the inflation rate. The real after-tax cost of debt is always much smaller than the interest rate. In fact, it occasionally becomes negative. Table 1 lists the average interest rate and the real cost of debt for U.S. nonfinancial corporations in selected years. TABLE 1 The Cost of Corporate Debt and Equity in the United States, percent   1974 1981 1988 Interest rate on AAA bonds, i 8.60 14.20 9.70 Inflation rate1, π 8.60 9.20 3.20 Real interest rate2, i* 0 5.00 6.50 Corporate tax rate3, τ 0.52 0.50 0.42 Real cost of debt after taxes4 -4.50 -2.10 2.40 Nominal cost of equity 16.20 16.30 9.50 Real cost of equity 7.60 7.10 6.20 NOTES: (1) Rate of change of the GNP deflator, fourth quarter to fourth quarter (2) (3) Including federal and state taxes. (4) THE COST OF EQUITY Stockholders invest in corporate equities in order to have future monetary returns. Corporations invest the stockholders' equity to

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering make an after-tax profit. Part of that profit is paid back to investors, and part of it is retained for reinvestment to generate progressively larger profits that will allow progressively higher cash payments to stockholders. A corporation's cost of equity is the rate of return stockholders demand. The concept is analogous to the definition of the interest rate, that is, the rate of return that lenders demand. There is, however, an important difference. Whereas the cost of debt to a corporation is less than the interest rate, the cost of equity in America is the same as the return demanded by stockholders. This is because no corporate tax deduction is provided for payments made by the corporation to its stockholders. The phrase "the return stockholders demand" used in the above definition, although widely used in economics, may sound strange to anyone but an economist. Everyone knows how lenders can enforce their demand to receive interest payments from a corporation. A loan constitutes a contractual obligation between the lender and the borrower, and if the borrower does not pay the contracted return, the lender can take legal action. On the other hand, equity holders have no legal recourse when a company fails to earn what stockholders require. They can, however, bid down the shares of the company until the share price reflects the earning power of the company, and hence, the required rate of return. A continuing market valuation of a company much below the replacement value of its net assets will at best deprive the company of access to new equity capital. At worst, the management may be replaced. This can occur either through the action of the company's board or, as often happens today, through an unfriendly takeover. To prevent such actions, managers will tend to increase payout in the form of dividends or stock repurchases and will reduce new investments. Empirical determination of the cost of equity is a somewhat complicated and frequently misunderstood process. To illustrate the point, consider the following example: Assume a company has net income of $50,000 per year, and the replacement value of its assets, less its liabilities, is $1 million. Thus, its return on equity is 5 percent. Let us further assume that the company pays out to its stockholders $20,000 per year, reinvests $30,000 per year at its historical return of 5 percent, and has a cost-of-equity equal to 10 percent. Under these assumptions, the market value of the company's stock will be $350,000. This reflects the $20,000 of distributed earnings that is valued at 10 to 1, plus $150,000 that represents $30,000 reinvested at half the required return. Thus, the market value of the company's equity is only 35 percent of its replacement value, or 70 percent of the value of its current earn-

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering ings divided by the required return. The return on the company's market value is $50,000/$350,000, or 14.3 percent and, the price-to-earnings ratio of the company is 7, namely, the inverse of 0.143. It is evident from the above that the cost of equity (10 percent) differs from the return on equity at replacement (5 percent), and from the inverse of the price-to-earnings ratio (14.3 percent). In general, these three parameters will also differ for any real-world company. CORPORATE HORIZONS AND THE COST OF CAPITAL The cost of capital divided by the cost of labor is a principal determinant of the capital-to-labor ratio in an industry. The capital-to-labor ratio, in turn, is an important determinant of labor productivity, and this is a key determinant of standard of living. These propositions are well accepted by economists, although there is disagreement concerning the extent to which capital-to-labor ratios affect productivity. Historically, economists define "capital" as hard assets such as plant and equipment, not soft assets such as technology. In recent years, however, such soft assets have become increasingly important. In fact, they may well be the most important type of capital for the industrial competitiveness of a high-wage country such as the United States. The reason for this shift in emphasis is that several countries, West Germany and Japan in particular, have reached a stage of technological development sufficient to compete with the United States in industries that are technology-intensive. Such industries command a higher price per unit of labor than do commodities-oriented industries, because fewer countries can compete. In addition, there are markets such as consumer electronics in which market dominance and product quality can provide a competitive edge sufficient to allow market leaders to command higher prices. Achievement of such dominance and quality also requires heavy intangible investments in marketing and product quality. Thus, for a high-wage country to be competitive, the most important attribute is to have a low cost of capital for soft or intangible investments. The problem of America's competitiveness in international trade is largely related to manufacturing. Changes in the trade balance in manufacturing were the principal cause of the U.S. trade deficit in the 1980s. Moreover, improved trade in products and services with high technological content is likely to be the principal means of reducing future U.S. trade deficits. For such products and services, intangible

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering investments are more critical to international competitiveness than are investments in fixed assets. As noted earlier, the cost of capital in general depends on the cost of debt, the cost of equity (which is much higher than that of debt), and the tax code parameters. Tax variables include the tax rate on corporate income, the investment tax credit, and the depreciation rate allowed for a given type of asset. For soft investments, however, the cost of capital is simply the cost of equity. This fact has important implications regarding national economic policy. There are two separate reasons why the cost of capital for soft investments is identical to the cost of equity. The first is that the tax codes of all countries provide for immediate expending of such investments. Because of that fact, the cost of capital becomes the after-tax cost of funds. In addition, because it is nearly impossible for lenders to assess the value of soft assets with any degree of certainty, such assets do not provide a suitable collateral for debt financing. The second reason is based on the fact that accounting rules in all countries require that soft investments be charged against current income. A reduction of current income can be justified to stockholders only if they perceive that such an investment is likely to produce sufficient income in the future that its discounted present value is greater than the cost of the investment. The applicable rate for such a discounting exercise is the cost of equity. We see, then, that the after-tax cost of equity controls not only the amount of the soft investments that a corporation makes, but also the time horizons of such investments. On the one hand, for a company or an industry to attain a significant advantage over its competitors, long-term investments are required. For example, it took more than 15 years for Japanese automakers to penetrate the U.S. market. Similarly, it may take more than 15 years to create a market for high-definition television. On the other hand, the longer it takes for a soft investment to produce profits, the greater will be the burden of a high discount rate. Thus, an investment decision that lowers earnings by $1 now, yet would raise earnings by $2, 15 years from now, is a profitable decision only if the firm's cost of equity is 5 percent or less. The same investment will lower the firm's value if its cost of equity is more than 5 percent. For a high-wage country, time horizons may very well be more important than the rate of investment in determining the nation's competitiveness. If this is true, then the cost of equity in and of itself is more important to the future of our nation than factors such as corporate tax rates, which affect the cost of hard assets.

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering INTERNATIONAL COMPARISONS Comparisons of the cost of capital in the major industrialized nations have been made by several investigators. Comparisons of the United States and Japan have attracted particular attention because Japan is viewed as the principal challenger to America's post-World War II industrial supremacy. Most of the studies that have appeared in the literature1 have a major weakness: They consider only the effects of interest rates and taxation. They omit other effects, such as risk, that have a dramatic effect on the cost of equity. Of the empirical studies that address the cost of equity in the United States and Japan, the most recent are Hatsopoulos and Brooks (1987), Ando and Auerbach (1989), McCauley and Zimmer (1989), and Bernheim and Shoven (1989). All of these studies find the U.S. cost of capital to be higher than that of Japan. What emerges from these studies is the following: Nominal interest rates are higher in the United States than in Japan, for example, 9.7 versus 4.3 percent in 1988.2 After adjusting for inflation, however, the difference has been much smaller in recent years. Corporate taxation is stiffer in Japan than in the United States, which means that if all other factors were the same, the cost of capital should have been higher in Japan. All other factors, however, are not the same. The first study to include risk, Hatsopoulos (1983), found that the principal factor driving the U.S.-Japan cost-of-capital gap was the high leverage of Japanese corporations. The last year considered in that study was 1981. Since then, Japanese leverage has declined, and U.S. leverage has increased.3 This convergence, as well as the previously mentioned convergence in real interest rates, has led some observers to conclude that the cost of capital in the two countries must also have converged. It has not. In the late 1970s, interest rates were lower in Japan than in the United States. But, because of differences in inflation rates, the real after-tax cost of debt was lower in the United States. The Japanese cost-of-capital advantage derived primarily from their much higher leverage, which meant that greater weight in the average cost of capital was placed on low-cost debt as opposed to high-cost equity. During the 1980s, the decline in the Japanese leverage advantage was offset by a decline in the U.S. advantage relative to real after-tax cost of debt. (The real after-tax cost of debt increased in both countries, from negative values to roughly equivalent levels of 2 percent after 1984.) Over the same period, the real after-tax cost of equity remained constant at about 2.5 percent in Japan and about 7 percent in the

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering United States. As a result, the gap in the cost of capital between the two countries was the same in 1988 as it was in 1979. Japan's exceptionally low cost of equity is truly startling. It is lower than interest rates and is now comparable to the real after-tax cost of debt. This may very well be the primary reason that the leverage of Japanese corporations has declined—it is now more advantageous to raise equity than to borrow money in Japan. The causes for such a low cost of equity have preoccupied many financial experts. Some have speculated that the high price of corporate shares in Japan is the result of escalation in land prices. This explanation is not convincing, for the observed decline in the discount rate of corporate equities is bound to be reflected in the rise in both the price of shares and the price of scarce corporate land. The rate of personal taxation on capital gains from corporate shares, together with certain features of Japan's financial structure, are more rational explanations. Until mid-year 1989, the tax rate on capital gains from equities was zero,4 whereas the maximum tax rate on all other capital gains, such as those resulting from the sale of real estate, was 50 percent. Thus, the enormous Japanese personal saving rate, typically 15 to 20 percent of disposable income, is directed in its entirety by the tax code toward corporate equities. In addition, the financial structure in Japan provides for a broad sharing of corporate risk throughout the society. More than half of the stock of an average Japanese corporation is held by other corporations and by banks. Banks, in turn, have been consistently supported by the Bank of Japan. The virtual elimination of barriers to capital flows from nation to nation has led many analysts and economists to believe that differences in cost of capital soon will be eliminated. Indeed, as we saw earlier, real interest rates in the United States and Japan have been converging. The same is true to some extent for other countries. Yet, the cost of equity in different countries is not converging. It appears that although funds to finance government bonds or bonds issued by major corporations tend to flow rather freely across borders, funds to finance equities, especially equities other than those of a few major corporations, do not flow freely. During the 21 months from January 1988 through September 1989, foreign investors acquired a net $336 billion of U.S. financial assets but only $4 billion of U.S. traded equities. Such disparity is understandable; except for a few large multinational corporations, most foreigners are not familiar with publicly traded companies in the United States. In addition to this lack of familiarity and trust on the part of foreign equity investors, there is the problem that corporate risks differ from country to country because of differences in financial structure.

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering It is apparent, for reasons previously noted, that corporations in Japan embody less risk for their stockholders than do equivalent corporations in the United States. The dramatic difference in the cost of equity between the United States and Japan raises serious concerns about our ability to maintain a high standard of living for our workers. If our cost of equity—that is, the rate at which U.S. managers must discount the future—does not become competitive with that of the major industrialized nations, the United States will have to surrender those industries that critically depend on long-term investments ranging from worker training to technology. Such a surrender will force us to compete with a growing number of low-wage countries that produce only commodities and mundane products and services. POLICIES THAT REDUCE THE COST OF EQUITY The principal factors that affect the cost of equity are the rate of domestic saving, the structure of personal taxes, and the structure of the financial markets. Increased domestic saving reduces the cost of equity, not only because it reduces interest rates and makes equity investments more attractive, but also because domestic saving rather than foreign saving is the principal source of equity funds. This means that a reduction of the federal deficit, the major detractor from domestic saving, can have significant beneficial effects in the long term, provided such a reduction does not adversely affect private saving. The structure of personal taxation also can have an important effect on the cost of equity. For example, if the double taxation of retained earnings and dividends is reduced, it is almost a certainty that the cost of equity will fall. The double taxation of retained earnings can be reduced through a tax exclusion for part of any future gains on equity investments. The double taxation of dividends can be reduced through a partial deductibility of dividends from corporate taxable income. Japan has successfully practiced both of these methods. An alternative approach is the integration of personal and corporate taxation as, for example, is already being done for Subchapter S corporations. Either of these methods would reduce revenues to the government. There are ways, however, to offset such revenue losses through other changes in the tax code. An increased corporate tax rate, for example, would have a relatively small detrimental effect on fixed capital formation, but would preserve all the benefits for intangible capital formation.

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering CONCLUSIONS The most important attribute required to sustain growth in America's standard of living in a competitive world is for our corporations to match the investment horizons of foreign competitors. To accomplish this, it is necessary—although probably not sufficient—to reduce the rate at which U.S. corporations discount future earnings. In fact, that discount rate must be made comparable to rates prevailing in the most competitive industrialized nations. Such convergence in discount rates will not occur automatically through the opening up of capital markets. Convergence requires appropriate economic and tax policies that gradually eliminate the current bias favoring consumption and debt relative to equity finance. NOTES 1.   For example, King and Fullerton (1984) and Bernheim and Shoven (1987). 2.   The rates cited are for Moody's AAA bonds in the United States and for Nippon Telephone and Telegraph bonds in Japan, respectively. 3.   See McCauley and Zimmer (1989). 4.   The 1989 tax reform in Japan provides for a taxation on capital gains from equities which ranges from 2 percent for an asset that has doubled in value, to 20 percent for an asset that has had a small increase in value. REFERENCES Ando, A., and A. J. Auerbach. 1990. The cost of capital in Japan: Recent evidence and further results. Paper presented at the conference on ''Corporate Finance and Related Issues: Comparative Perspectives, Tokyo, Japan, 7-8 January 1990. Bernheim, B. D., and J. B. Shoven. 1986. Taxation and the cost of capital: An international comparison. Paper presented at the American Council for Capital Formation Conference on Consumption Tax: A Better Alternative? 3 September 1986. Dertouzos, M. L., R. K. Lester, and R. M. Solow. 1989. Made in America: Regaining the Productive Edge. Cambridge, Mass.: MIT Press. Hall, R. E., and D. W. Jorgenson. 1967. Tax policy and investment behavior. American Economic Review 57(3)(June): 391-414. Hatsopoulos, G. N. 1983. High cost of capital: Handicap of American industry. Paper presented at American Business Conference and Thermo Electron Corporation, 26 April 1983. Hatsopoulos, G. N., and S. H. Brooks. 1986. The gap in the cost of capital: Causes, effects, and remedies. Pp. 221-280 in Technology and Economic Policy, R. Landau and D. Jorgenson, Ballinger eds. Cambridge, Mass.: Ballinger. Hatsopoulos, G. N., and S. H. Brooks, 1987. The cost of capital in the United States and Japan. Paper presented at the International Conference on the Cost of Capital, Kennedy School of Government, Harvard University, 19-21 November 1987. McCauley, R., and S. Zimmer. 1989. Explanations for International Differences in the Cost of Capital. New York: Federal Reserve Bank of New York.

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Technology & Economics: Papers Commemorating Ralph Landau's Service to the National Academy of Engineering   GEORGE N. HATSOPOULOS is the founder, chairman of the board, and president of Thermo Electron Corporation, a company that manufactures instruments, cogeneration systems, process equipment, and biomedical products and provides environmental and metallurgical services. He received his education at the National Technical University of Athens and the Massachusetts Institute of Technology, where he received his bachelor's, master's, engineer's, and doctoral degrees in mechanical engineering. He served on the faculty of MIT and has continued his association with the Institute, currently serving as senior lecturer. He is principal author of Principles of General Thermodynamics and Thermionic Energy Conversion, Volumes I and II. He has published more than 60 articles in professional journals on thermodynamics, energy conversion, energy conservation, energy productivity, capital formation, cost of capital, and the international competitiveness of American industry. Dr. Hatsopoulos is a member of the governing council of the National Academy of Engineering and is a fellow of the American Academy of Arts and Sciences, the American Society of Mechanical Engineers, and Institute of Electrical and Electronics Engineers.