Money, Financial Crises, and Business Cycles

Edward C. PrescottJuly 7, 2010

Messages

• Monetary Policy has little real effects

• Financial crises are symptoms and not cause of economic downturns – crises sometimes lead to good regime changes and sometimes to bad

• A big looming problems is efficiently financing retirement consumption – it can be done

2

3

Macro Theory Works

• Given productivity, population, and taxes:

– Predicted and actual paths of the aggregate variables coincide

– All using dynamic economic theory to construct models consistent with the national accounts and other data find same thing

– All find monetary policy had little real impact

4

What Gave Rise to Post 1960 Contractions and Expansions?

• All graphs per working-age person and adjusted for secular living standard growth

• Flat line is healthy trend growth with living standards doubling every generation

5

The Biggest ExpansionTechnology Driven

90

95

100

105

110

1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I

* Quarterly trend growth: 0.45%

Period Average = 100

6

The Biggest ContractionTax Rate and Productivity Driven

90

95

100

105

110

1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I

* Quarterly trend growth: 0.45%

Period Average = 100

7

The Longest ExpansionTax Rate and Productivity Driven

90

95

100

105

110

1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I

* Quarterly trend growth: 0.45%

Period Average = 100

8

The 1990s ExpansionTechnology Driven

90

95

100

105

110

1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I

* Quarterly trend growth: 0.45%

Period Average = 100

Best Indicator of Current Situation is Market Hours, Not GDP!

• I use household survey measures of hours worked (CPS)

• There are serious problems with establishment based hours estimates

• GDP is only part of output and is revised in major ways as more data becomes available

• CPS market hours are revised little

Source: Cociuba (FBR Dallas), Prescott (ASU & FBR Minn.), and Ueberfeldt (Bank of Can.)

1200

1300

1400

1500

1600

Trough: 2009-III

Peak: 2008-II

US Annual Hours per Working Age Person 2001-I to 2010-I

11

Hours Drop between 2008.II and 2009-III

11 %!

12

Has Output Started to Recover?

NO! • Businesses have cut intangible capital investment

– R&D, human capital investment, advertising

• Intangible investment is not part of measured output – because it is expensed

Output = GDP + Intangible capital investment

• Preliminary detrended GDP flat last three quarters

• Detrended output almost surely fell

13

Note: Fluctuations Not Due to Monetary Policy!

• Nor lack of borrowing

14

Liabilities of Households and of Nonfinancial Businesses They Own

End 2007 End 2008 End 2009

Total Liabilities (trillion US$) 32.5 33.2 32.9Composition Shares Mortgages 44.9% 44.4% 43.1% Business Borrowing 38.3% 39.5% 39.3% Other 16.8% 16.1% 17.6%

Source: Flow of Funds, March 11, 2010 Release, Tables L100 and L101

Reason for Not so Great Current Depression is NOT Recent Financial Crisis!

• Businesses have funds or access to borrowing to make profitable investments

• Currently U.S. banks are lending huge amounts to the Federal Reserve Banks

• This lending is at a low rate– 0.25% nominal– negative real

• Problem: Banks do not have good lending opportunities

16

Then What Depressed the U.S. Economy

• Fact: Investment suddenly became depressed beginning early in 2008 – because of a policy regime change

• Business owners feared higher tax rates with the regime change and – Rationally cut investment – Rationally cut employment – Rationally took more cash out of business

• Workers fearing job loss rationally cut auto buying

Private Investment Is Depressed (2006 Q4 = 1)

0.4

0.6

0.8

1

1.2

1.4

I/Y

C/Y

G/Y

2001 2002 2003 2004 2005 2006 2007 2008 2009

Y GDPC Private ConsumptionI Private InvestmentG Government Expenditures

18

Fears Are Being Realized

• Tax rates are being increased

• These increases lower amount of capital a firm chooses to have

• Reason for low investment is not problem of getting loans – it is expected future high tax rates

19

What Happened after Financial Crises?

Sometimes bad thingsand

Sometimes good things

Numbers are trend corrected so flat line is growing at trend

20

Finland Good and Japan Bad

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

60

80

100

120

140GDP per Capita Detrended at 2% 1992 = 100

Source: GGDC (PPP-EKS) Japan

Finland

21

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

60

80

100

120

140

Chile Great and Mexico Terrible Detrended at 2% 1980 = 100

Chile

Mexico

Source: GGDC (GK-PPP)

22

Others Financial Crises

• U.S. 1981: good policy regime change

• U.S. 1989-90 : bad change

• Asia 1997 : good change

• U.S. 2008 : bad change

• Euro Zone 2010: probably good change

23

What are Good and Bad Policy Regime Changes?

• Good: Cut tax rates and therefore expenditures; Follow productivity growth policies

• Bad: increase expenditures and therefore taxes now and/or in the future; cater to special interest groups which blocks productivity growth

24

A Looming Financial Problem:Financing Retirement Consumption

• The ratio of retirees to workers is going up

• Can’t increase transfers to old because higher tax rates will not increase revenue

• With current tax system there will be an over-accumulation of capital and dynamic inefficiency

U.S. Has a Big Capital Stock:5.8 GNPs

Legal Ownership

Stock Source

Government 0.6 GNPs BEA

Tangible Private 3.5 GNPs BEA

Intangible Private 1.7 GNPs McGrattan & Prescott, AER,

Sept 2010Total 5.8 GNPs

But, most is Owned by the Government

Economic Ownership

Stock in GNPs

Government 3.0

Private 2.8

Total 5.8

27

What Can Be Done?

Answer: Eliminate taxes on capital income!

• Will increase private saving stock net of government debt

• Will increase the market value of businesses by– Shifting most of its ownership from the public to

private sector • Will increasing private saving opportunities

Legal and Economic Ownership are Different Concepts and it is the Economic Concept that

must be Used in Economic Analyses

• Economic ownership of a stream of distributions means that the owner can transform this stream into an equal valued stream of consumption

• If 50% of a legally owned stream is taken as taxes, economic and government ownership are both 50%

• The tax on pension payments is approximately 50% in the U.S. so the government owns half our pension savings

There are Solutions to the Problems

• The Saving for Retirement Problem– Solution – Shifting economic ownership of a large

part of the capital stock from the public to the private sector by eliminating capital income taxes

• The Current U.S. Depression– Cut tax rates and expenditure and stop catering to the

special interests groups