Unexpectedly Intriguing!
December 11, 2006

Somehow, somewhere, Edward Prescott lost two macroeconomic myths between today's column in the Wall Street Journal (excerpted here via Mark Thoma) and a recent presentation he made back in October to the Economic Club of Phoenix. We here at Political Calculations thought it might be interesting to see what got clipped from the Nobel prize winner's previous mythbusting list!

First, here's Tyler Cowen's thumbnail summary of the five that were included in today's WSJ:

Myth No. 1: Monetary policy causes booms and busts.
Myth No. 2: GDP growth was extraordinary in the 1990s.
Myth No. 3: Americans don't save.
Myth No. 4: The U.S. government debt is big.
Myth No. 5: Government debt is a burden on our grandchildren.

And now, drum roll please, from the mess of scraps we found cluttering the floor of the Wall Street Journal, here are the missing two myths:

Myth No. 6 (originally Myth No. 3): The 1978-82 recession was caused by tight monetary policy. Here's what Prescott had to say about this particular myth (From the WP Carey business school's record of Prescott's Phoenix presentation):

"Everybody says that former Fed Chairman Paul Volcker caused the 1978-82 recession with his tight money (high real Federal Funds rate) policies," suggested Prescott. But looking at the data historically, there is no consistent relationship between monetary policy and real economic activity.

"Between 1975 and 1980 monetary policy was very loose (the real Federal Funds rate was low)," Prescott said. At the same time, output trended upward until 1979, when it began a downward trend.

Yet even though output began a downward trend in 1979, the Fed didn't significantly tighten monetary policy until 1981. Then, output continued its downward trend through 1982, when it began to climb again -- even though monetary policy was still tight.

In the end, Prescott says, he doesn't see any relationship between the real economic activity and monetary policy during the 1975-85 period.

And now, the one, the only, and the original Myth No. 7: U.S. economy is doing much better than the European economy! Here's what Prescott had to say about that (again from the Phoenix presentation):

It's true, Prescott said, that the labor supply is depressed in Europe. "They have a problem and they understand that." But Europe's problems, Prescott suggests, are policy related. "Europe is as productive as the U.S.," Prescott said. "It's just that their tax rates are too high and as a result they work too little." Germany, France and Italy will follow the lead of the United Kingdom and Spain and cut their tax rates. This will result in these countries catching up to the United States in terms of GDP per capita.

Like Europe, per capita GDP in the U.S. has been roughly on trend since 1991, with the exception of the boom in the late 1990s.

In Japan, in contrast, productivity stopped between 1992 and 2002. Prescott conjectures that this occurred because Japan's bureaucratic industrial banking complex subsidized inefficient businesses in this period. "A firm will not make a needed investment to become more efficient if its competitors are subsidized. Because of the subsidies to competitors, there is not a return on this investment. The incentives are perverse," Prescott said.

Don't make us do this again, Wall Street Journal! We like *all* our macroeconomic myths to get busted (preferably by professionals.) And scrub your floors while you're at it!

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