Edward C. Prescott – How to Restore US Prosperity?


Operations Research and The Revolution in Aggregate Economics – Edward Prescott 2012

The extension of recursive methods to dynamic equilibrium modelling spawned a revolution in aggregate economics.

This revolution has resulted in aggregate economics becoming, like physics, a hard science and not exercises in storytelling.

Operations research played a major role in the development of practical methods to model dynamic aggregate economic phenomena and to predict the consequences of policy regimes.

Subsequently recursive methods were used to develop a quantitative theory of aggregate fluctuations and other aggregate phenomena.

The contribution of the random fortunes of large firms to business cycle volatility, or how a single, small, dirty pipe threatened to bring a nation to its knees

One contaminated pipe at a milk processing factory of New Zealand’s largest company, Fonterra, New Zealand’s largest company (7% of GDP) and largest exporter caused such a loss of brand-name value of the company that the New Zealand Treasury revised down its GDP forecasts for the year.

It is a little bit scary to wonder what kind of nation we live in when a single, small, dirty pipe threatens to bring the nation to its knees. That indeed was the fear when, over the weekend, Fonterra announced the contamination of a small amount of whey powder from a Waikato processing plant – Bank of New Zealand

This growth forecast revision after the milk contamination scandal, but turn out to be false reading, is a good example of how the random fortunes of individual large companies can have economy-wide implications and can even lead to recessions.

Figure 1: Sector’s concentration (Herfindahl Index) and sector’s contribution to aggregate volatility

Source:  (Gabaix 2011).

There is growing evidence that idiosyncratic shocks to the fortunes of the 100 largest firms arising from changes in demand and cost conditions in their local and export markets combine to contribute about one-third of up-swings and downswings in U.S. output and employment (Gabaix 2011).

In an economy dominated by a few large firms, idiosyncratic shocks to large firms do not cancel out. The ups and downs in the individual fortunes of very large firms combine with firm-to-firm linkages to travel far beyond the firm and sector of origin (Gabaix 2011). These effects are likely to be stronger outside of the USA because it has a more diversified economy than most countries (Gabaix 2011).

Di Giovanni and Levchenko (2010) found that having fewer and less diversified firms and exports dominated by large firms helps to explain why small, more open economies such as New Zealand are more volatile. Fonterra accounts for 7 per cent of GDP and 20 per cent of overall exports. Drought is important to the New Zealand business cycle and agricultural exports (Buckle, Kim, Kirkham, McLellan and Sharma 2007).

As another example of the importance of a few large firms, Samsung and Hyundai account for 35 per cent of Korean exports and 22 per cent of Korean GDP.It would not be a good idea for the chief executives of those two Korean businesses to travel in the same car and have an accident.

Finland was monikered the one-firm economy because Nokia was responsible for 1/5th of Finnish economic growth, exports and company tax revenues for two decades. Nokia shares initially fell by 90 per cent in 2007 when Apple leap-frogged it with an iPhone that resembled a PC. The loss of one product development race imperilled the foundation of one-fifth of Finnish economic growth.

The literature on the contribution of large firms to business cycle volatility is a good examples of how the real business cycle theory is alive and well and is a progressive research programme.

Keynesian macroeconomics as a form of juvenile real business cycle theory (RBC)

Keynesian macroeconomics postulated that the economy slips into recessions for all sorts of reasons such as shifts and turns in the animal spirits and a loss of consumer confidence leading to a fall in autonomous investment and autonomous consumption. A collapse in autonomous investment and autonomous consumption is the Keynesian explanation for the great depression.

Both Keynesian macroeconomics and real business cycle theories, at least at the outset couldn’t explain why there were recessions. Both attributed to them to causes they were yet to explain. Keynesian macroeconomics  could not explain what drove the waves of optimism and pessimism that  either sharply increased or reduced investment.

Real business cycle theorists attributed recessions and booms to productivity drops in productivity surges, which initially were not explained in themselves. This theory sees productivity shocks as the cause of economic fluctuations. For example, if productivity falls, current returns to working and investing decline, so workers and firms choose to work and invest less and take more leisure. Real business-cycle theory views a recession as the optimal response by households and firms to a shift in productivity.

At least Prescott and other real business cycle theorists accepted that they must eventually unpack productivity drops and name causes that can be explored further and perhaps found persuasive or perhaps wanting.

Keynesian macroeconomics was quite happy to live with the waves of optimism and pessimism of the animal spirits that drove investors to push the economy into recessions. In his General Theory of Employment Interest and Money) Keynes puts it this way,

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

A far better explanation of the animal spirits is there is a productivity drop in one sector of the economy that leads that sector to reduce its demand for inputs supplied by the rest of the economy. This reduction in demand spreads across the economy. The slowdown in the economy is attributed to this  reduction in demand, rather than the forces behind it,  which is a fall in productivity in one sector of the economy.

Long and Plosser in 1983  wrote a famous article where they were able to generate business cycles in an economy  with rational expectations, complete current information, stable preferences,  no technical change,  no long-lived commodities, no frictions and adjustments cost,  no government, no money  and no serial dependence in the stochastic elements of the environment.

In response to a productivity disturbance in one sector this economy,  consumers will smooth a change in their consumption possibilities and production possibilities over a number of  quarters  by saving  and dissaving and varying the amount of time they devote to work and leisure and they will invest more or less in light of the changing situation.

This  consumption smoothing  is enough to generate a slowdown in the economy from changes in one sector. Laid-off workers in the sector subject to a disturbance will take time to find jobs in other sectors of the economy and  will be unemployed in this interim period of job search. Other workers who were previously employed in the sector subject to the productivity decline might wait for prospects to improve in that sector rather than search for a job in another occupation or location.

As research progressed, real business cycles were  viewed as recurrent fluctuations in an economy’s incomes, products, and factor inputs—especially labour—due to changes in technology, tax rates and government spending, tastes, government regulation, terms of trade, and energy prices. In his Nobel lecture Ed Prescott explained that:

We learned that business cycle fluctuations are the optimal response to real shocks.

The cost of a bad shock cannot be avoided, and policies that attempt to do so will be counterproductive, particularly if they reduce production efficiency.

During the 1981 and current oil crises, I was pleased that policies were not instituted that adversely affected the economy by reducing production efficiency. This is in sharp contrast to the oil crisis in 1974 when, rather than letting the economy respond optimally to a bad shock so as to minimize its cost, policies were instituted that adversely affected production efficiency and depressed the economy much more than it would otherwise have been.

By the time Keynesian macroeconomics papered over the flaws mighty exposed by the 1970s stagflation, it rebranded itself New Keynesian macroeconomics. This is no more than becoming monetarist macroeconomists without having to admit all of your previous criticisms of Friedman were wrong.

At bottom, Keynesian macroeconomics makes an unjustified assumption that technological progress unfolds at a relatively smooth rate, and changes in government regulation, terms of trade, and energy prices were not important sources of economic fluctuations. As for tax rates and government spending, Keynesian macroeconomists saw these is a solution to recessions rather than their cause.

In time, real business cycles theory and Schumpeterian theories of business cycles will merge. new inventions and processes that are, by the nature of research and development, stochastically discovered. Part of this randomness in discovery will be that the emergence from time to time of great interventions –  general purpose technologies -that result in economy wide changes and a wave of secondary inventions and the retraining of the workforce and reallocation of many workers into new sectors of the economy. These great inventions can be anything from electricity to information and computer technology and the Internet