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Monday, December 11, 2006

Prescott: Five Macroeconomic Myths

Here's a glimpse at how a proponent of Real Business Cycle (RBC) models sees the world. These are "Five Macroeconomic Myths" according to Ed Prescott, co-winner of the Nobel Prize in economics in 2004.

Not everyone would agree, however, that these are all myths. New Keynesians view the world through a different theoretical framework and therefore do not necessarily come to the same conclusions. One area of disagreement, for example, is over the ability of monetary and fiscal policy to stimulate real economic activity.

New Keynesians believe policy can affect the course of the economy and improve macroeconomic performance, while RBC adherents believe that policy is mostly neutral or, if poorly managed, negative in its impacts on real variables such as output and employment. Thus, RBC proponents do not believe in trying to stabilize the economy using monetary policy, tax changes, or changes in government spending, instead they recommend that the government get out of the way as much as possible and allow the private sector to take care of any problems that might arise. They argue for minimal government involvement in the economy and for policies that allow the private sector to respond optimally to changing economic conditions (however, while there is merit to this approach up to a point, see today's column by Paul Krugman on taking this idea too far).

My own view is that there are things to learn from the RBC approach and we should certainly implement polices that enhance growth, e.g. tax policy should pay attention to economic incentives. But there is strong evidence to suggest that macroeconomic stabilization policy is necessary and useful in smoothing the economy and there is merit in New Keynesian ideas as well.

In addition, within the economic arena, I believe there is a role for government to play over and above stabilization policy in correcting market failures either through regulation or through provision of the good or service itself (e.g. anti-trust regulation, health care, social security, etc.) that goes beyond what most RBC advocates would find acceptable.

Here are Prescott's myths:

Five Macroeconomic Myths, by Edward Prescott, Commentary, Wall Street Journal: The sky is not falling. No need to panic and start playing around with all sorts of policy responses. Despite the impression created by some economic pundits, the U.S. economy is not a delicate little machine that needs to be fine-tuned with exact precision by benevolent policymakers to keep from breaking down. Rather, it is large and complex, with millions of people making billions of decisions every day to improve their lives...

On the one hand, it's difficult to screw up all these well-intentioned people by crafting bad policy, but, on the other hand, it is of course entirely possible to do so. And once things are broken, they are much harder to fix. For example, all those doomsayers predicting a recession will get their wish if taxes are suddenly raised, new productivity-strangling regulations are enacted, the U.S. turns against free trade, or some combination thereof. Otherwise, we should expect 3% real growth, based on 2% increases in productivity and 1% population growth. This economy is fundamentally sound.

So we have to be careful that we don't believe everything we read in the papers. ...[P]olicy should not be revised at every turn, nor rules changed by political whim. ... One of the great disciplines of economics is that it challenges us to question status quo thinking. So let's take a look at five pillars of contemporary conventional wisdom that have current standing, and see how well they hold up.

Myth No. 1: Monetary policy causes booms and busts. ...

One of the mysteries of the 1990s is how to explain the economic boom when the increase in capital investments -- as measured by the national accounts -- grew at a subdued pace. The numbers simply don't add up. However, it turns out that something special happened in the 1990s, and it wasn't monetary policy. In a recent paper, ... Ellen McGrattan and I show that intangible capital investment -- including R&D, developing new markets, building new business organizations and clientele -- was above normal by 4% of GDP in the late 1990s. ... Output, correctly measured, increased 8% relative to trend between 1991 and 1999, which is much bigger than the U.S. national accounts number of 4%. ...

What about busts? Let's begin with the assumption that tight monetary policy caused the recession of 1978-1982. ... To accept the myth, you have to accept a consistent relationship between monetary policy and economic activity -- and ... this relationship is simply not evident in the data. ... Our obsession with monetary policy in the conduct of the real economy is misplaced.

One caveat: I am not saying that there are no real costs to inflation -- there certainly are. And if we get too much inflation we can exact high costs on an economy (witness Argentina as an example). However, I am talking here of the vast majority of industrialized countries who live in a low-inflation regime... It is simply impossible to make a grave mistake when we're talking about movements of 25 basis points.

Myth No. 2: GDP growth was extraordinary in the 1990s. Even though I referred to the expansion of the '90s as a boom, inasmuch as it was a period of above-trend growth, and I noted the strong gains due to unmeasured investment, we have to put things into historical context. So let's return to the data. GDP growth relative to trend in the early 1960s was 12%, and in the famous 1980s boom (from the end of 1982 to mid-1989) it was a very impressive 9.7%. ...

So we have to be careful about mythologizing the 1990s and drawing misguided policy lessons; yes, it was a boom, and it was better than we think, but let's keep that boom in perspective.

Myth No. 3: Americans don't save. This is a persistent misconception owing to a misunderstanding of what it means to save. ... Our traditional measures of savings and investment, the national accounts, do not include savings associated with tangible investments made by businesses and funded by retained earning, government investments (like roads and schools) and business intangible investments.

If we want to know how much people are saving, we need to look at how much wealth they have. ... Viewing the full picture -- economic wealth -- Americans save as much as they always have... We're saving the right amount.

Myth No. 4: The U.S. government debt is big. ...[L]et's turn to the historical data once again.

Privately held interest-bearing debt relative to income peaked during World War II, fell through the early 1970s, rose again through the early 1990s, and then fell again until 2003. Even though that number has been rising in recent years (except for the most recent one), it is still at levels similar to the early 1960s, and lower than levels in most of the 1980s and 1990s. ... From a historical perspective, the current U.S. government debt is not large.

Myth No. 5: Government debt is a burden on our grandchildren. There's no better way to get people worked up about something than to call on their sympathies for their beloved grandkids. ... But we should stop feeling guilty -- at least about government debt -- because we are in better shape than conventional wisdom suggests.

Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. ... Currently, privately held public debt is about 0.3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt.

What's going on here? There are not enough productive assets -- tangible and intangible assets alike -- to meet the investment needs of our forthcoming retirees. ... The fix comes from getting the proper amount of government debt. When people did not enjoy long retirements and population growth was rapid, the optimal amount of government debt was zero. However, the world has changed, and we in fact require some government debt if we care about our grandchildren and their grandchildren.

If we should worry about our grandchildren, we shouldn't about the amount of debt we are leaving them. We may even have to increase that debt a bit to ensure that we are adequately prepared for our own retirements.

There are at least three lessons here. First: Context matters. Take what you read in the paper with a many grains of historical salt. Second: Current data often provide poor guidance for effective policy making. To make forward-looking policies you have to understand the past. Finally: Establish good rules, change them infrequently and judiciously, and turn the people loose upon the economy. Booms will follow.

Update: Greg Mankiw adds:

Now I am confused: In today's Wall Street Journal, economist Ed Prescott ... writes about five macroeconomic myths. This passage left me scratching my head:

Myth No. 5: ...Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. ...

Usually, even when I disagree with a fellow economist, I can understand his point of view. But I am puzzled about this passage. Ed must have some model in mind, but I am not sure what it is.

To some degree, it sounds like Ed is worried that the U.S. economy might accumulate more capital than what Ned Phelps called the "Golden Rule" level. ... Phelps used a Solow growth model to show that an economy can potentially save beyond the point that maximizes steady-state consumption. Peter Diamond subsequently showed that such excessive saving can potentially arise even when overlapping generations of consumers make individually optimal saving decisions. This situation is sometimes called "dynamic inefficiency." When the economy is dynamically inefficient, government debt would have the virtue of depressing the capital stock to its optimal level.

Andy Abel, Larry Summers, Richard Zeckhauser, and I once wrote a paper on this topic. We concluded that while dynamic inefficiency was possible in theory, it was not a problem in practice. Is Ed coming to the opposite conclusion, or does he have something else in mind? I am not sure.

    Posted by on Monday, December 11, 2006 at 12:06 AM in Economics, Macroeconomics, Policy | Permalink  TrackBack (3)  Comments (35)


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    » Five macroeconomic myths? from Marginal Revolution

    Here is Ed Prescott's list. Here is the thumbnail version: Myth No. 1: Monetary policy causes booms and busts Myth No. 2: GDP growth was extraordinary in the 1990s Myth No. 3: Americans don't save Myth No. 4: The U.S. government debt is big Myt... [Read More]

    Tracked on Monday, December 11, 2006 at 01:36 PM

    » Two Missing Macroeconomic Myths from Political Calculations

    Somehow, somewhere, Edward Prescott lost two macroeconomic myths between today's column in the Wall Street Journal (excerpted here via Mark Thoma) and a recent presentation he made back in October to the Economic Club of Phoenix. We here at Political C... [Read More]

    Tracked on Monday, December 11, 2006 at 09:04 PM

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    Tracked on Tuesday, December 12, 2006 at 02:48 AM


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