Effective Measures Against the
Recession
Edward C. Prescott
July 6, 2009
1

U.S. Long‐Run Picture
• Relatively steady growth over the last 150
years
• Some fluctuations about trend (HP filtered)
Source of following pictures is Robert E. Lucas, Jr.
2

3

Deviations From Trend
• Relative to trend, GDP lost 40% between 1929
and 1933
• Recently the loss has been about 5%, and most
of this is in 2008‐IV and 2009‐I
4

5

How Bad Are Things?
Not that bad, so far
6

Contractions (Recessions)
• Recession is not an economic concept
• An economy can’t be in one or not in one
• Prior to development of modern macro, it was
not a well‐defined empirical concept
• It was totally discredited by Nobel Laureate
T. J. Koopmans in his devastating critique of
Burns and Mitchell (the NBER definitions) as
measurement without theory
7

Sensible Definition of a Contraction
• Any sensible definition corrects for
population and trend growth
• A flat line is neither losing nor gaining
ground relative to the industrial leaders
• A flat line means living standards double
every generation
8

Detrended GDP per Person 16‐64 1959‐I to
2009‐I
110
Period Average = 100
105
100
95
* Quarterly trend growth: 0.45%
90
1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I
9

Now There Is Hard Theory
• Given productivity, population, and taxes:
– Predicted and actual paths of the aggregate
variables coincide
– All using dynamic economic theory to
construct models consistent with national
account and other data find same thing
– We find monetary policy had little
consequence
10

Contractions: Detrended GDP
per Person 16‐64 1959‐I to 2009‐I
110
Period Average = 100
105
100
95
* Quarterly trend growth: 0.45%
90
1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I
11

Contractions
• Biggest contraction was 11.2% from 1978‐IV to
1982‐IV
– First two years of it, money was loose– low
real interest rate
– Last two years and beyond, money was tight
• The contraction beginning in 1999‐IV was
bigger than figure indicates because
– There was a huge amount of unmeasured
investment in the second half of the 1990s
12

Expansions
• Big expansion of early 1960s was technology
driven
• The 1995‐2000 expansion was technology driven
– And in fact was significantly bigger and
longer than standard statistics indicate
– Reason: Huge unmeasured intangible
investment (R&D, launching new products)
• The second biggest and the longest expansion
was in the 1980s and was due to cuts in
marginal tax rates
13

Expansions: Detrended GDP
per Person 16‐64 1959‐I to 2009‐I
110
Period Average = 100
105
100
95
* Quarterly trend growth: 0.45%
90
1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I
14

What Depressed the U.S. Economy in
2008‐IV and 2009‐I?
• Fed did what it should given the situation
– Big increase in reserves
• Fed is not the cause of the recent drop in
U.S. GDP (4.0% trend corrected and probably
another 1.0% this quarter)
• Not the financial crisis
• Not lack of borrowing
15

Liabilities of Households and of
their Nonfinancial Businesses
End 2007 End 2008
Total Liabilities
(billions $) 31,875 32,341
Composition Share
Mortgages 44.9% 44.4%
Other Loans 18.0% 18.5%
Corporate Bonds 11.2% 12.0%
Security credit 1.0% 0.5%
Trade payable 8.2% 8.5%
Other 16.8% 16.1%
16

Then What Depressed the U.S. Economy in
2008‐IV and 2009‐I‐II?
• Fact: Investment became depressed
• There are 25 million small businesses in the
U.S. – 5 million of them have employees
• Their owners feared higher tax rates
– Rationally cut investment
– Rationally cut employment
– Took more cash out of business
• Workers fearing job loss rationally cut auto
buying
17

Fears Are Being Realized
• Tax rates are being increased
• These increases lower amount of capital a
firms chooses to have
• Reason for low investment is not problem of
getting loans – it is expected high tax rates
18

What Happened after Financial Crises?
Sometimes bad things
and
Sometimes good things
Numbers are trend corrected so flat line is
growing at trend
19

Experiences Very Different
GDP per Capita Detrended at 2% 1992 = 100
140
Finland
120
100
80
Japan
Source: GGDC (PPP-EKS)
60
1990 1994 1998 2002 2006
20

GDP per Capita Detrended at 2% 1980 = 100
140
Chile
120
100
Mexico
80
Source: GGDC (GK-PPP)
60
1980 1984 1988 1992 1996 2000 2004
21

Cost of Current Crisis
• Huge bailout of lenders to financial
intermediaries by taxpayers
• This means higher tax rates in future and
depresses the economy now
• The so‐called stimulus plan is a depressant
plan
22

Evidence that High Marginal Tax Rates
Depress an Economy
• This uses the simple methodology developed in
my American Economic Association 2002 Ely
Lecture
• Factors other than the marginal tax rate
matter
• Also errors in measuring hours worked
23

Predicted vs. Actual Weekly Hours
predicted
30.0
Japan
28.0 Australia
New Zeland Iceland
26.0
Ireland
Portugal Romania
Spain
24.0 U.S.
U.K.
22.0 Canada
20.0 France Germany Denmark
Italy
18.0
16.0
16.0 18.0 20.0 22.0 24.0 26.0 28.0 30.0
actual 24

Effective Measures Against the
Depression in U.S. Economy
• Cut marginal tax rates
• Become more open
• Follow pro‐productivity policies
25

Openness and Spain’s GDP Per Capita
Relative to U.S.
Moderately Integrated Before 1930 42%
Little Integrated 1940‐54 22%
Moderately Integrated 1965 36%
Becomes EU Member 1981 49%
Highly Integrated 2007 61%
26

Government Spending Doesn’t Stimulate the
Economy
27

Summers’ Misguided Advice to Japan
• Repeatedly said to spend and stimulate their
economy in 1990s and Japan did
• What happened? Japan lost a decade of growth
• Geithner, who is not an economist, is now
advising China to spend in order to stimulate
its economy
28

Why Japan’s Lost a Decade of Growth?
• Some blamed China
• Others blamed the Bank of Japan
• Still others blamed fiscal policy
– Said Japan needed even bigger deficits
• Hayashi and Prescott in “Japan’s Lost
Decade of Growth” find the problem was
lack of productivity growth!
29

Why Low Productivity Growth?
• Hayashi and I conjectured: banks subsidizing
inefficiencies
– Loans were being made to pay interest on
existing loans
– Banks’ liabilities exceeded assets
• Subsidizing inefficient businesses deters
productivity growth
30

Japan’s Reaction
• Cabinet Research Office invited me to talk in
2002
• Signaled Prime Minister Koizumi was buying
into the productivity story
• Takenaka, new head of Financial Services,
instituted banking reforms
31

Banking Reforms
• Wrote off bad loans
• Refinanced insolvent banks
• Required honest accounting when meeting
capital requirements
32

What Happened After Reforms
• Productivity growth rebounded
– No helicopter drops of money
– No big increases in spending
– No Chinese collapse
• Reason for rebound
– Making the banking system sound again
33

Detrended GDP per Capita
110
US
100
90
Japan
80
70
EU - 15
60
1991 1993 1995 1997 1999 2001 2003 2005
34
Source: GGDC

An Efficient Crisis‐Free Financial System
• Friedman argues for 100% reserve banking with
interest on reserves
• Justification is stability
• I argue for Friedman’s system for the
commercial banking system
35

Good Financial Regulation
• Friedman argues for 100% reserve banking
• Justification is stability
• I argue for 100% reserve commercial banking
system (with interest on reserves)
• AND a ban on financial intermediation, which
rules out Bear Stearns and Lehman Brothers
36

Regulation Depresses Productivity
• Actions are often taken for political reasons
• Recent financial crisis and earlier S&L
crisis due to policies designed to increase
home ownership
• Fannie Mae and Freddie Mac, two government‐
sponsored enterprises, began holding subprime
mortgages because politicians forced them to
• Congress passed laws that effectively
required banks to make subprime mortgage
loans when enforced
37

Financial Intermediation Serves No
Purpose
• Financial intermediation is when a limited
liability business borrows from one group and
lends to another, and is highly leveraged
• It is just gambling on a grand scale
• When financial intermediaries get big, the
taxpayers bail them out when they fail
• As a taxpayer, I don’t like bailing out
Goldman Sachs, AIG, and Deutsche Bank
38

How Are Investments Financed?
• Currently 80 percent financed by equity and
mutual lending
• Other 20 percent financed by bank lending
• The part currently financed by bank lending
would have to be financed other ways
39

What Other Ways?
• Use more equity
• Use more mutual lending
– Mutual insurance companies
– Venture capital group
– REITS
– Mutual pension funds
– Hedge funds that do not borrow
• With this reform, all commercial bank lending
to government
40

Don’t Increase Tax Rates
• European hours per working‐age person 70% of
other advanced industrial countries
• Why? Their marginal effective tax rate is 60%
versus 40% elsewhere
• In early 1970s tax rate was 40% and they
worked the same amount
41

• European hours per working‐age person 70% of
other advanced industrial countries
• Why? Their marginal effective tax rate is 60%
versus 40% elsewhere
• In early 1970s tax rate was 40% and they
worked the same amount
• Danger: U.S. will increase its tax rate
42

Raising Tax Rates Will
• Not increase revenue in the U.S.
• Will decrease revenue in France, Italy,
Germany, and Spain
43

44

Welfare
• Because of taxes, the value of time on
margin is twice as high as in the
market sector as outside market sector
• Nonmarket time is valuable
• Welfare gains lifetime consumption
equivalents per year are …
45

46

What Matters Are Real Factors
• Tax RATES – low rates good
• Openness – more is better
• Productivity – higher is better
• Problem is not lack of borrowing
• Some banks are refusing deposits in the U.S.
47

Poor Prospects for U.S.
Productivity Growth: Why?
• Recent abandonment of cost‐benefit analysis
for evaluation of new regulations
• Government ownership of auto and banks
• Congress and the White House management of
businesses
48

Are We in for Another Great Depression?
• The current planned policies in U.S. resemble
those followed in 1929‐32
– Anti immigration
– Anti globalization
– Pro tax increase
– Pro White House managing the economy
– Pro bailout of businesses
– Pro cartelization
49

I Expect Not
• Things were going well for the U.S. economy
until the fourth quarter of 2008 – rapid
productivity growth
• Economic knowledge has advanced so much that
it will effectively constrain the
policymakers
• But, I fear a lost decade of growth for the
U.S. because of tax rate increases and low
productivity growth
50