Robert Lucas on the causes of business cycles

I was [initially] convinced by Friedman and Schwartz that the 1929-33 down turn was induced by monetary factors…

I concluded that a good starting point for theory would be the working hypothesis that all depressions are mainly monetary in origin. Ed Prescott was sceptical about this strategy from the beginning…

I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks.

But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008. Of course, this means I have to renounce the view that business cycles are all alike!

Robert Lucas Jr.

Europe has extensive experience with currency union break-ups

  • The Latin Monetary Union (LMU) joined Belgium, Italy, and Switzerland together with France in 1867. The arrangement managed to hold together until the generalized breakdown of global monetary relations during World War I.
  • The Scandinavian Monetary Union (SMU) formed in 1873 by Sweden and Denmark and two years later by Norway. This was disrupted by the suspension of convertibility and floating of individual currencies at the start of World War I. the agreement was finally abandoned in 1931.
  • The Austro-German Monetary Union was dissolved in less than a decade following Austria’s defeat in the 1866 Austro-Prussian War.
  • The only truly successful monetary union in Europe came in 1922 with the birth of the Belgium-Luxembourg Economic Union (BLEU), which remained in force for more than seven decades until 1999.
  • Europe in the twentieth century has also seen the disintegration of several monetary unions, usually as a by-product of political dissolutions.
  • A celebrated instance is after the Austro-Hungarian Empire was dismembered by the Treaty of Versailles. Almost immediately, in an abrupt and quite chaotic manner, new five currencies were introduced.
  • There also have been British and French currency unions with and between colonies.

Since World War II, economies have exited currency unions at an average rate of one per year.

Andrew Rose found

…that countries leaving currency unions tend to be larger, richer, and more democratic; they also tend to experience somewhat higher inflation.

Most strikingly, there is remarkably little macroeconomic volatility around the time of currency union dissolutions, [emphasis added] and only a poor linkage between monetary and political independence.

Indeed, aggregate macroeconomic features of the economy do a poor job in predicting currency union exits.

Rather than saying Euroland cannot fall, the discussion should be dissolutions of currency unions are common, especially when Greece is a member. What happened? How was it done?

HT: Monetary Unions.

The U.S. and Euro-zone non-recoveries

Screen_shot_2014-06-13_at_11.50.26_am

HT: Vox.com from oecd.org

How Does The U.S. Jobs Recovery Compare?

US comparison

Image

Employment losses after financial crises

FinanacialCrises0514

HT: oregoneconomicanalysis.com

Why Robert Lucas disagreed with Keynesian macroeconomics

Proponents of a class of models which promised 3 1/2 to 4 1/2 per cent unemployment to a society willing to tolerate annual inflation rates of 4 to 5 per cent have some explaining to do after a decade such as we have gone through [i.e., the 1970s, when inflation rose to 16 per cent and unemployment to 8 per cent in the United States, and to 30 per cent and 6 per cent in the U.K. Inflation rose as high as 25 per cent in Japan and 7 per cent in Germany, though unemployment remained relatively low].

A forecast error of this magnitude and central importance to policy has consequences, as well it should.

The Obama recovery

image

The deviation from trend is widening.

HT: John Lott

The Shadow Fed – documenting the road not take since 1973

The Shadow Open Market Committee was founded in 1973 by Karl Brunner and Allan Meltzer.

The Committee was founded because many monetarist economists believed the Federal Reserve (The Fed) caused a recession by failing to keep money supply growth steady. Its members were academics and from private organisations.

The original objective was to evaluate the policy choices and actions of the Fed’s Open Market Committee, the arm of the Fed which ran monetary policy in the USA.

The  Shadow Open Market Committee meets semi-annually. A number of papers are prepared by  Shadow Open Market Committee members on macroeconomic and public policy topics.

Based on these papers and the Committee’s deliberations, a policy statement summarises the policy recommendations of the Committee. 

These papers are organised by year and downloadable at ShadowFed | Official Site of the Shadow Open Market Committee.

Bob, this is the way labour markets works, Ed

Robert Lucas Edward C. Prescott

Bob,
This is the way labour markets work: v(s, y, λ) max{λ, R(s, y) min[ λ, β ∫ v(s′, y, λ) f(s′, s)ds′]}.
Ed

Robert Lucas went on to explain in his professional memoir about this exchange in the early 1970s that:

we had agreed on notation: s stood for the state of product demand at a particular location, y stood for the number of workers who were already at that location, R(s, y) was the marginal product of labour implied by these two numbers, and v(s, y) stood for the present value of earnings that one of these workers could obtain if he made his decision whether to stay at this location or leave optimally.

Other features of the equation were as novel to me as they are (I imagine) to you…

a single parameter—Ed’s λ—stood for two different things: the present value of earnings that all searching workers would have to expect in order to leave a location and the present value that a particular location would need to offer to receive new arrivals…

If I had to pick a single day to represent what I like about a life of research, it would be this one.

Ed’s note captures exactly why I think we value mathematical modelling: it is a method to help us get to new levels of understanding the ways things work.

Piketty: A Wealth of Misconceptions by Don Boudreaux

Piketty’s method of doing economics involves frequent grand proclamations about "social justice" and economic "evolutions," but he offers no analyses of the dynamics of individual decision-making, often referred to as "microeconomics," that should be central to the issues he raises…

Revealingly, Piketty writes of income and wealth as being claimed or "distributed," never as being earned or produced. The resulting statistics are too aggregated—too big-picture—to reveal what is happening to individuals on the ground…

He imagines that such aggregates interact in robotic fashion through a logic of their own, unmoved by individual human initiative, creativity, or choice…

If we follow the advice of Adam Smith and examine people’s ability to consume, we discover that nearly everyone in market economies is growing richer…

THE U.S. IS THE bête noir of Piketty and other progressives obsessed with monetary inequality.

But middle-class Americans take for granted their air-conditioned homes, cars, and workplaces—along with their smartphones, safe air travel, and pills for ailments ranging from hypertension to erectile dysfunction…

At the end of World War II, when monetary income and wealth inequalities were narrower than they’ve been at any time in the past century, these goods and services were either available to no one or affordable only by the very rich.

So regardless of how many more dollars today’s plutocrats have accumulated and stashed into their portfolios, the elite’s accumulation of riches has not prevented the living standards of ordinary people from rising spectacularly…

Piketty’s disregard for basic economic reasoning blinds him to the all-important market forces at work on the ground—market forces that, if left unencumbered by government, produce growing prosperity for all. Yet, he would happily encumber these forces with confiscatory taxes.

via Piketty: A Wealth of Misconceptions – Barron’s.

Robert Lucas on the role of income redistribution in economic development

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Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution.

In this very minute, a child is being born to an American family and another child, equally valued by God, is being born to a family in India.

The resources of all kinds that will be at the disposal of this new American will be on the order of 15 times the resources available to his Indian brother.

This seems to us a terrible wrong, justifying direct corrective action, and perhaps some actions of this kind can and should be taken.

But of the vast increase in the well-being of hundreds of millions of people that has occurred in the 200-year course of the industrial revolution to date, virtually none of it can be attributed to the direct redistribution of resources from rich to poor.

The potential for improving the lives of poor people by finding different ways of distributing current production is nothing compared to the apparently limitless potential of increasing production.

via The Industrial Revolution: Past and Future 2003 Annual Report Essay by Robert E. Lucas, Jr

Edward C Prescott – Restoring U.S. Prosperity – Brazil, 10 May 2014

 

Can New Zealand blame its small size for its economic woes?

The median national population size is not much more than New Zealand’s current population.

  • Controlling for location, Easterly and Kraay (2002) found that smaller states were richer than other states in per capita real GDP.
  • Rose (2006) reviewed the impact of size on the level of income, inflation, material well-being, health, education, and the quality of a country’s institutions and found that small countries are more open to trade than large countries, but are not systematically different otherwise.

As I argued in my previous post on distance, New Zealand were prosperous from the time of European settlement despite a small population and their great distance from the main markets of the world on each side of the Atlantic.

Of the ten richest countries in terms of GDP per capita, only four have populations above one million people (Alesina 2003). These countries are the USA (290 million people), Switzerland (7 million people), Norway (4 million people) and Singapore (3 million people). Of these four nations, two are below the global national population median of six million (Alesina 2003).

New Zealand’s population is similar and often larger in size than most of the richest countries in the world. Singapore and Hong Kong were initially far from the global Trans-Atlantic economic hubs before their respective development miracles unfolded in the mid and late 20th century.

Something must have happened recently for either small population size or distance to have become important when it was not important for most of the history of New Zealand. New Zealand has been on the same place on the map for all its history.

Transport costs on exports to England and the rest of Europe did not hold back New Zealand’s economic development in the 19th century and for most of the 20th century despite far more primitive and more expensive forms of transport.

New Zealand specialised in commodities that could be produced at a low cost because land and water was plentiful and exported them in bulk to large markets on the other side of the world because of falling transport costs. The invention of refrigeration in 1881 was a major boost to meat exports to England.

The main economic difference between smaller and larger nation-states around the globe is smaller nations are more open to international trade and foreign investment (Alesina et al. 2005).

In a world of freer overseas trade, small countries can extend the size of their markets by trade and sidestep many of the costs of small internal markets. As long as political borders do not greatly limit international trade, economic success is increasingly independent of national size (Alesina 2003; Alesina et al. 2000).

A leading economic advantage of large national size in more isolationist times was a large marketplace free of trade and investment barriers and fewer national borders and different legal systems to parry. As more nations open up to the world, the single market benefits of large size for a country start to melt away quickly (Alesina 2003; Alesina and Spolaore 2003; Alesina et al. 2000).

As countries become larger, administration costs and the growing heterogeneity in the political preferences of larger and more diverse populations counterbalance the benefits of size and scale (Alesina et al. 2003, 2004, 2006; Spolaore 2006). More nation-states and freer trade increase the degree that governments must compete for citizens and investment. Inter-jurisdictional competition increases the incentives for governments to adopt institutions and policies that promote efficiency and productivity and serve their peoples better (Friedman 2005).

Foreigners Are Our Friends | Bryan Caplan | Learn Liberty – YouTube

Can New Zealand blame distance for its economic woes?

Distance is common in many discussions of the relative growth performance of New Zealand. New Zealand is said to be small and remote and poorer for it. The figure below from a Productivity Commission report is an example.

The Productivity Commission put it this way:

New Zealand firms face reduced access to large markets and limited participation in global value chains, where the transfer of advanced technologies now often occurs.

Indeed, global value chains – which can require intensive interaction and just-in-time delivery across borders – may have worsened the impact of New Zealand’s geographic isolation on trade in goods.

The Commission continues on to say that:

These limits on trade and the diffusion of new ideas into New Zealand may explain as much as 15 percentage points of the 27% productivity gap between New Zealand and the average of 20 OECD countries.

This 15 per cent claim is a daring claim. Physical location does not change over time.

New Zealand, Australia and the other European offshoots such as Canada and the USA all prospered for most to all their histories despite their distances from their mother country. Canada cannot blame distance for its weak productivity performance because it is next door to the USA.

Figure 1 below using OECD data suggests that New Zealand and Australian real GDP per capita are both about 10 percentage points lower than they otherwise would be because of distance. A bounty of natural resources gives a less than a two per cent boost to Australia’s real GDP per capita, see Figure 1.

Figure 1: Estimated impact of proximity to markets and natural resources on real GDP per capita, OECD members, average for 2000-2004

Source: OECD.

The burden of geography is about distance from large agglomerations of production, consumption and supply. There is from the extra cost of exporting to distant markets and the cost penalty from ordering from major suppliers who are far way. Geography can also affect the international flow of ideas and the diffusion of new technologies.

Figure 2 shows that most of the labour productivity gap of New Zealand and many others with the USA is not explained by geography – by access to major markets and any natural resource bounty.

Figure 2: Apparent and geography adjusted hourly labour productivity relative to the USA, 2006


Source: OECD (2008).

New Zealand’s apparent and geography adjusted productivity gaps with the USA are not far apart. In contrast, the OECD (2009c), geography cuts in half the gap in hourly labour productivity between the USA and Australia – see Figure 3.

Figure 3: Percentage point change in hourly labour productivity relative to the USA due to geography, 2006

Source: OECD.

The labour productivity gap of New Zealand with the USA is over four times larger than what could be reasonably attributed to geographic burdens. Other factors must account for the bulk of New Zealand’s productivity gap.

More to the point, distance and remoteness explain none of the productivity and income gaps across the Tasman and why this gap suddenly appeared in the 1970s and 1980s to NZ’s disadvantage.

New Zealand lost almost two decades of growth between 1974 and 1992 as shown in Figure 4.

Figure 4: Real GDP per New Zealander and Australian aged 15-64, converted to 2013 price levels with updated 2005 EKS purchasing power parities, 1956-2012

Source: Computed from OECD StatExtract and The Conference Board, Total Database, January 2014.

The Trans-Tasman gap is the income and productivity gap that concerns Kiwis and is the relevant policy yardstick everyone uses or should use.

The emergence of the Trans-Tasman income gap from initial income parity in 1974 – see Figure 4 – cannot be because of distance because both NZ and Australia suffer equally from a 10% productivity burden because of distance.

This common 10% productivity burden due to distance does not explain real GDP per working age person in Australia and NZ dropping from parity in 1974 to a 35% gap inside 20 years and then suddenly stabilising.

Figure 4 showed that NZ started growing again in 1992 after the Ruth Richardson horror budget stabilised economic policy sentiments. There was to be no going back on the economic reforms.

Figure 5 below shows that NZ’s labour productivity growth dropped like a stone between 1974 and 1992 then stabilised at 1.85% growth per year from 1992 to 2005. GDP per working age person in Figure 5 is based to 100 in 1974 and then detrended by 1.85% per year – the trend growth rate of the USA in the 20th century. A flat line in Figure 5 is annual growth in real GDP per working age person of 1.85%. Australia’s growth rate is pretty flat since 1970 bar the odd recession and recovery from the same.

Figure 5: Real GDP per New Zealander and Australian aged 15-64, converted to 2013 price levels with updated 2005 EKS purchasing power parities, base 100 in 1974, 1.85 per cent detrending, 1956-2012

Source: Computed from OECD StatExtract and The Conference Board, Total Database, January 2014.

This 34% productivity drop in NZ from 1974 to the mid-1980s was too rapid to be explained by distance and global value chains suddenly becoming more important than was the case for most of NZ’s history. Australian GDP growth rates was not affected in the slightest by these trends in the geography of trade and input markets.

The Productivity Commission looked at the wrong data to ask the wrong questions. The data analysis undertaken on behalf of the Productivity Commission started in 1980. Figure 6 below shows at all the action and excitement regarding total factor productivity in New Zealand occurred before 1980.

Figure 6: New Zealand total factor productivity and real GDP per New Zealander aged 15-64, 2 per cent detrended, 1955-2000

Source: Kehoe and Ruhl (2003).

Kehoe and Ruhl (2003) attributed the decline in the growth of GDP per working age New Zealander after 1974 to 1992 to a sharp decline in total factor productivity from 1974 to 1980.

Figure 6 plots detrended data constructed by Kehoe and Ruhl (2003) to show that total factor productivity fell rapidly in New Zealand between 1974 and 1980, by 30 per cent in all, and then levelled out to grow again at the trend rate of two per cent.

There was no subsequent total factor productivity recovery to make up the lost ground. If this were so, Figure 4 would have had to include a strongly rising line for total factor productivity over many years after 1980 to recover the 30 per cent fall in the level of total factor productivity between 1974 and 1980.

Kehoe and Ruhl (2003) suggested that the identification of the factors that permanently reduced total factor productivity levels in New Zealand between 1974 and 1980 may have great contemporary policy relevance.

The total factor productivity drop identified by Kehoe and Ruhl (2003) occurred before the 1978 start of the Statistics New Zealand productivity data series.

The great value of the Kehoe and Ruhl (2003) data is the drawing out of the major decline in total factor productivity on the eve of the Statistics New Zealand data series.

Kehoe and Ruhl (2003) attributed the 1970s total factor productivity collapse to a massive change in trade patterns after the entry of the UK into the then European Economic Community in 1973.

All discussions of income gaps should be against Australia and any additional burden of distance that New Zealand faces in addition to Australia since 1974 when the Trans-Tasman income gap emerged.

When New Zealand catches-up with Australia in labour productivity that will be the time to start worrying about the burden of geography – a burden that holds back relative productivity equally in both countries. You cannot explain the difference between Australia’s and NZ’s relative productivity by geographic factors they have in common.

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