How Can Spain and the U.S. Recover from their Depressions

Edward C. Prescott

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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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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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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

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

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

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

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

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

Reason for Not so Great Current Depressionis 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

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

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

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

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

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

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

Increasing Marginal Tax Rates will Not Increase tax Revenue

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GDP and Tax Revenue per Person

00.20.40.60.8

11.21.41.6

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Tax Rate, t

GDP

Tax Revenue

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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 …

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Welfare Gains and Losses

-20%

-10%

0%

10%

0 0.1 0.2 0.3 0.4 0.5 0.6

Current U.S.

Europe

Tax Rate

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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

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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

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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

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Liabilities of Households and of Nonfinancial Businesses They Own

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%

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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

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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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Predicted vs. Actual Weekly Hours

GermanyFranceItaly

Canada

U.K.

Japan

U.S.Spain

IrelandIcelandNew Zeland

Australia

Denmark

Portugal Romania

16.0

18.0

20.0

22.0

24.0

26.0

28.0

30.0

16.0 18.0 20.0 22.0 24.0 26.0 28.0 30.0

actual

predicted

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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