1. How Can Spain and the U.S. Recover from their Depressions Edward C. Prescott

2. 2 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.

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4. 4 Deviations From Trend  Relative to trend, GDP lost 40% between 1929 and 1933  Recently the loss has been about 8%, and this has occurred over the last 14 months

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6. Stock of Intangible Capital is Huge  It is as big as the stock of tangible capital –Tangible capital is about 3.8 times GDP, which is measured output –This is $190,000 for every man, woman, and child  Tangible capital includes –Houses, factories, vehicles, roads, office buildings, retail stores, some software, computers, etc

7. Reason for Depression Was Not the Financial Crisis  Except through policies it led U.S. to adopt  Depressed U.S. economy depressed rest of world  China, India, and Brazil have already resumed healthy growth  Europe, with exception of some Mediterranean countries, will soon

8. What Are the Roles of Financial System?  Saving for retirement  Financing capital –In the US of the 3.4 GDPs of private capital half equity (owner) financed half financed by debt this is the case for real estate, which is the biggest component of capital

9. Total Household Borrowing Equals Total Household Lending  Lenders are people saving for retirement  Borrowers are people who own businesses with debt –This debt is the debt of the owners –Household businesses have big debt –Unincorporated businesses have big debt –Corporate businesses have big debt

10. Parallels Between Current and the Great Depression  Both started with collapse of a real estate boom  Both started with the near complete cut off of immigration  Both times, stimulus plans were instituted with large increases in spending and taxes  Both times, there was a shift to anti-trade policies  Both times, the White House started managing the economy

11. The Reason that the US Economy had a Great Depression in the 1930s and is Currently Depressed is NOT the Financial Crisis  No financial crisis until U.S. was well into the Great Depression  And then it was a small crisis  Businesses had funds to make profitable investments  Businesses had huge cash flows  They paid big dividends rather than financing investments with retained earnings  This implies a lack of perceived profitable investments

12. Reason for Not so Great Current Depression is the Same  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

13. Current US Depression  Politicians are trying to foster more construction even though there is an excess supply of houses.  One way to stimulate the depressed construction industry is to destroy half the housing stock –If done, there would be a construction boom –This would be bad policy

14. U.S. Should Ban Institutions that Borrow from One Group and Lend to Another and are Highly Leveraged  Such as Long Term Capital Management, Bear Stern, Lehman Brothers  Mutual lending organizations are good –People lend and bear the risk of bad loans –Institutions like Caja Navarra should be encouraged –Mutual pension funds should be encouraged –Mutual bond funds should be encouraged  Reserve requirements for commercial banking should be high and government insured deposits minimal

15. What Depressed the Economy today and in the 1930s?  Not market failure  Rather failure of the central government  If people expect higher tax rates on distributions from their businesses in the future, they rationally – cut investments now and – increase current distributions

16. What Will Make the Economy Boom  Cut marginal tax rates –People will work more –Businesses will invest more –Output and personal consumption will increase  Be open  Do not erect barriers to the use of better production processes

17. Another Way: Pray for Another Technology Boom  The economy will boom if there are abnormally large increase in the technology level as happened in the first half of the 1960s and last half of the 1990s –Politicians should not pander to special interest groups with vested interest in currently use inferior technologies of production –If they do, there will be no boom as barriers to using the new superior technologies will be erected

18. Cutting Government Expenditures Will Help  The increased expenditures in World War II increased employment and output  But it reduced welfare as household consumption and leisure fell – just as theory predicts  Governments should make investments only if the benefits exceed the costs –If benefits exceed costs, they stimulate the economy –If not, they depress the economy

19. Increasing Marginal Tax Rates will Not Increase tax Revenue

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21. 21 Welfare  Because of taxes, the value of time on margin used in market sector is twice that used in nonmarket sector (If tax rate 50%)  Nonmarket time is valuable  Welfare gains in lifetime consumption equivalents per year are …

22. 22 Tax Rate

23. 23 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 national account and other data find same thing –All find monetary policy has and had little real consequence

24. 24 Then What Depressed the U.S. Economy  Fact: Investment suddenly became depressed in the last third of 2008 – there was a regime change  There are 25 million small businesses in the U.S. and 5 million of them have employees  Their owners feared higher tax rates with the regime change and they –Rationally cut investment –Rationally cut employment –Took more cash out of business  Workers fearing job loss rationally cut auto buying

25. 25 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

26. 26 Liabilities of Households and of Nonfinancial Businesses They Own End 2007End 2008 Total Liabilities (billions $)31,87532,341 Composition Share Mortgages44.9%44.4% Other Loans18.0%18.5% Corporate Bonds11.2%12.0% Security credit1.0%0.5% Trade payable8.2%8.5% Other16.8%16.1%

27. 27 Cost of Current Crisis  Huge bailout of lenders to financial intermediaries by taxpayers  This means higher tax rates in future and a depressed economy now  The ‘stimulus’ plan is a depressant plan  To argue spending stimulates the economy is equivalent to arguing cigarettes are good for your health or CO2 is not a greenhouse gas

28. 28 Evidence that Low Marginal Tax Rates Boost an Economy  This uses the simple methodology developed in my American Economic Association 2002 Ely Lecture  Factors other than the marginal tax rate matter, so fit not perfect  Also errors in measuring hours worked

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30. 30 Effective Measures Against the Depression in U.S. Economy  Cut marginal tax rates  Become more open  Follow pro-productivity policies  Reform labor market policies so workers move quickly from where they are less productive to where they are more productive