Money, Financial Crises, and Business Cycles Edward C. Prescott July 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 Expansion Technology Driven

6 The Biggest Contraction Tax Rate and Productivity Driven

7 The Longest Expansion Tax Rate and Productivity Driven

8 The 1990s Expansion Technology Driven

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.) 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 2007End 2008End 2009 Total Liabilities (trillion US$) Composition 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)

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 things and Sometimes good things Numbers are trend corrected so flat line is growing at trend

20 Finland Good and Japan Bad

21

22 Others Financial Crises U.S. 1981: good policy regime change U.S : bad change Asia 1997 : good change U.S : 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 OwnershipStockSource Government0.6 GNPsBEA Tangible Private3.5 GNPsBEA Intangible Private1.7 GNPsMcGrattan & Prescott, AER, Sept 2010 Total5.8 GNPs

But, most is Owned by the Government Economic Ownership Stock in GNPs Government3.0 Private2.8 Total5.8

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