shANGHAI dECEMBER 9 th 2010

1. Financial Crises and Business Cycles Edward C. Prescott shANGHAIdECEMBER 9th 2010

2. the Chinese economy (at current exchange rates) has recently become the second-biggest economy • At PPP, it is now 80% of the U.S. and almost certainly will surpass the U.S. in a few years • It is still only 25% on a per capita basis, but will be 50% in 2024 if the current trend continues • The set of rich countries is expanding steadily. By the end to this century, I predict the whole world will be rich China

3. The currently rich will be much richer than they are today • Some countries will temporarily shift to bad policy regimes and lose ground relative to trend • For example, Japan in the 1992-2002 period • And U.S. beginning in 2007 Spectacular Catch-Up in Asia

4. In fact, the American financial system is very good and getting better • The financial system channels saving to most productive investment at low costs • Diversifying idiosyncratic risk is now possible at very low cost Financial Crisis Symptom, Not Cause of Depressed U.S. Economy

5. The world is changing and historical financial relations no longer hold • A prime example is the market value of corporations relative to GDP • In U.S. it has varied by factor of 2.5 post-1960 • In U.K. by a factor of 3.0 post-1960 • Was puzzling because everything else stays more or less constant relative to GDP • Including after-tax corporate profits Value of Corporations

6. These movements are accounted for by changes in tax and regulatory systems • Stock market value is excessively volatile, but regresses to fundamentals • The excess volatility puzzle has been open for 35 years • With the advances in economic theory, I confidently predict it will be resolved in the not-too-distant future Now Have Good Theory of Secular Movements in Value of Corporations Relative to GDP

7. If one expects current taxation of distribution not to change significantly, the market is 25% undervalued • Given my expectations as to future tax rates, the number is 5% Is the Market Overvalued?

8. Relatively steady growth over the last 150 years • Some fluctuations about trend (HP filtered) • Graphs courtesy of Robert E. Lucas, Jr. Long-Run Economic Picture

9. Secular Growth: U.S. Per Capita GDP

10. Relative to trend, GDP was 33% below trend in 1933 • For the 9 years 1930-38, hours over 20% below average • Recently, GDP 10% below trend with the fall occurring between May 2008 and October 2009 • U.S. trend growth is almost 3% • 1% population plus 2% living standard growth Deviations From Trend

11. Tools used to develop this theory were developed by Kydland and Prescott • Use explicit dynamic equilibrium models with people making consistent decisions • These models are restricted by growth facts and observation at the firm and household levels Now We Have a Tested Theory of the Movements in Output and Market Hours

12. The economy is depressed about 10% relative to trend. • Good news: Over the past 9 months, U.S. economy has bottomed out after falling for 17 months. • Bad news: The economy is not recovering. • I fear the U.S. will lose a decade of growth as did Japan beginning in 1992. • Why? Because U.S. is doing what Japan did – adopting anti-productivity growth policies. The Current Not-so-Great Depression

13. 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 become available • CPS market hours are monthly and are not revised Best Indicator of Current Situation Is Market Hours, Not GDP!

14. Percentage Deviation Hours per Person2008 Q1 = 0

15. U.S. Annual Hours per Working-Age Person 2001-I to 2010-I

16. 10%! Hours Drop between 2008.II and 2009-III

17. 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 • Detrendedoutput almost surely fell Has Output Started to Recover?

18. In 1990s, big boom in market hours per working-age person, but small boom in GDP, i.e., measured output • Intangible investment (unmeasured output) jumped • Currently, big drop in market hours and modest drop in GDP • Intangible investment has fallen • See McGrattan and Prescott, Unmeasured Investment and the Puzzling 1990s Boom, Minneapolis FRB Staff Report 369, forthcoming in American Journal of Economics: Macroeconomics • See also McGrattan and Prescott, RES 2005, JET 2009, AER forthcoming Intangible Investment Big and Variable

19. 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 What Gave Rise to Post-1960 Contractions and Expansions?

20. Detrended GDP 1959-I to 2009-IV

21. The Biggest Expansion Technology Driven

22. The Biggest ContractionTax Rate and Productivity Driven

23. The Longest ExpansionTax Rate and Productivity Driven

24. The 1990s Expansion Technology Driven

25. Recent ContractionTax Rate and Productivity Driven

26. No lack of borrowing Note: Fluctuations Not Due to Monetary Policy!

27. Liabilities of Households and of Nonfinancial Businesses They Own Source: Flow of Funds, March 11, 2010 Release, Tables L100 and L101

28. We won’t know for sure until the data needed to answer this question are available in a couple of years • But something can be said based on limited data now available • Both times, stimulus plans were instituted with large increases in spending and taxes • Both times, there was a shift to anti free trade policies • Both times, the White House started managing the economy Why Is the U.S. Economy So Depressed?

29. End of small high-tech boom • Overbuilding of houses • Spending increases that necessitate higher future taxes • Paying people not to work • Anti-productivity growth policies being adopted Factors Depressing Market Hours

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

31. 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 paid big dividends rather than financing investments with retained earnings • This implies a lack of perceived profitable investment opportunities Reason for the Great Depression 1930s NOT a Financial Crisis

32. 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 Reason for Current Not-so-Great Depression NOT Recent Financial Crisis

33. Such as Long-Term Capital Management, Bear Stearns, Lehman Brothers – they are small part of financial sector • Mutual lending organizations are good • People lend and bear the risk of bad loans • 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 Should Ban Institutions that Borrow from One Group and Lend to Another and Are Highly Leveraged

34. Because of regulations, S&L banks were highly profitable • Every big S&L had a member of U.S. House of Representatives on its board in the 1960s • People paying the regulatory rents were the households • Most S&L banks became insolvent and went bankrupt in 1988-1990 • It cost taxpayers 2% of GDP • Led to increased tax rates, which ended the tax-rate-cut boom of the 1980s Politics Led to U.S. Financial Problems

35. 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 Depressed the Economy Today and in the 1930s?

36. Cut marginal tax rates • People will work more • Businesses will invest more • Output and personal consumption will increase • Be open • China is setting up a manufacturing plant in South Carolina • Do not erect barriers to the use of better production processes by catering to special interest groups What Will Make the Economy Boom?

37. 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 the same thing • All find monetary policy had little real impact Macro Theory Works

38. Fact: Investment suddenly became depressed in the last third of 2008 – Reason: 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 Then What Depressed the U.S. Economy?

39. Private Investment Is Depressed (2006 Q4 = 1)

40. 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 and higher costs due to bad regulation Fears Are Being Realized

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

42. Experiences Differ after Financial Crises

43. GDP per Capita Detrended at 2% 1980 = 100

44. The ratio of retirees to workers is going up given the low birth rates and falling mortality rates • The case for China • Can’t increase transfers to old because higher tax rates will not increase revenue • People investing more given current tax system will lead to wasteful overaccumulation of productive assets (2006 Nobel Prize winner Edmund S. Phelps) A Looming Financial Problem:Financing Retirement Consumption

45. The total stock of these assets is 5.8 times GDP • Less than half is effectively owned by the the private sector • Following Samuelson, I use the overlapping generations abstraction, which implies government debt is part of the net worth of households • The U.S. balance sheet is The Amount of Productive Assets Is Large

46. U.S. National Balance Sheet

47. Given tax rates (consumption plus income taxes) are about 40%, the government owns 40% of pension fund assets • Given that government tax rate on distributions by businesses to owners is about 1/2, government owns 1/2 of business productive assets • In the U.S., given the property tax, the same is true for real estate owned directly by households

48. Limits on tax & transfers • Increased tax rates will not increase revenue to finance transfers • Limits on amount of government borrowing • Governments inevitably default on their borrowing • Argentina and Greece • More privately owned and less publicly owned capital is the way to increase private savings opportunities without capital over-accumulation Some Policy Constraints

49. Answer: Eliminate taxes on capital income! • Will increase private saving stock net of government debt • Will increase market value of businesses by • Increasing share of capital owned by private sector • Increasing the stock of capital, which increases wages and salaries • Have Robeco China and similar institutions direct savings to investment efficiently So What Should Be Done?

50. Countries that control government spending and are not piggish will do well • Poland, Brazil, India, China, Canada, and other Asian countries have been and are doing well • Europe in response to sovereign debt crisis appears to be on verge of doing this • In time, the U.S. will as well • Getting rid of capital income taxation will solve the shortage-of-savings-opportunities problem Conclusion