Summary of Macroeconomic Priorities (Robert Lucas)

  • Macro was born in the 1940s as response to the Great Depression in order to prevent a similar situation from occurring again. Lucas believes that macro has been successful, but that emphasis needs to shift.
  • In particular, “There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management.”
  • His summation “it is unrealistic to hope for gains larger that a tenth of a percent from better countercyclical policies.”
  • He then presents a couple of studies and their ultimate findings to support the above statements
  • Growth Theory looks at the evolution of an economy over time, using consumer preferences, technology and government policies as model sources. “In general, these studies found that reducing capital income taxation from its current U.S. level to zero (using other taxes to support an unchanged rate of government spending) would increase the balanced-growth capital stock by 30 to 60 percent. With a capital share of around 0.3, these numbers imply an increase of consumption along a balanced growth path of 7.5 to 15 percent. Of course, reaching such a balanced path involves a period of high investment rates and low consumption. Taking these transition costs into account, overall welfare gains amount to perhaps 2 to 4 percent of annual consumption, in perpetuity.”
  • Looks at Prescott’s analysis of Europe, stating “he shows that tax differences can account for the entire difference in hours worked and, amplified by the indirect effect on capital accumulation, for the entire difference in production. The steady state welfare gain to French households of adopting American tax rates on labor and consumption would be the equivalent of a consumption increase of about 20 percent. The conclusion is not simply that if the French were to work American hours, they could produce as much as Americans do. It is that the utility consequences of doing so would be equivalent to a 20 percent increase in consumption with no increase in work effort! The gain from reducing French taxes to U.S. levels can in part be viewed as the gain from adopting a flat tax on incomes,3 but it is doubtful that all of it can be obtained simply by rearranging the tax structure. It entails a reduction in government spending as well, which Prescott interprets as a reduction in the level of transfer payments, or in the government provision of goods that most people would buy anyway, financed by distorting taxes.”
  • Does some ‘thought-experiments’, results in Question “I ask what the effect on welfare would be if all consumption variability could be eliminated.” and Answer “trivally small… .0005”.
  • Shapiro and Watson in 1988 attempt to “break down the variance of production and other variables into a fraction due to what these authors call “demand” shocks (and which I will call “nominal” shocks) and fractions due to technology and other sources.”
  • “Shapiro and Watson find that at most 30 percent of cyclical output variability can be attributed to nominal shocks. Working from the opposite direction, Prescott and Aiyagari conclude that at least 75 percent of cyclical output variability must be due to technology shocks….Even so, on the basis of this evidence I find it hard to imagine that more than 30 percent of the cyclical variability observed in the postwar U.S. could or should be removed by changes in the way monetary and fiscal policy is conducted.”
  • Alvarez and Jermann in 2000 find that “The gain from the removal of all consumption variability about trend, estimated in this way, is large–around 30 percent of consumption.15 This is a reflection of the high risk aversion needed to match the 6 percent equity premium, and can be compared to Tallarini’s estimate of 10 percent. But the gain from removing risk at what Alvarez and Jermann call business cycle frequencies–cycles of 8 years or less–is two orders of magnitude smaller, around 0.3 percent. Most of the high return on equity is estimated to be compensation for long term risk only, risk that could not be.” “The great contribution of Alvarez and Jermann is to show that even using the highest available estimate of risk aversion, the gain from further reductions in business cycle risk is below one-tenth of one percent of consumption. The evidence also leaves one free to believe–as I do–that the gain is in fact one or two orders of magnitude smaller.”
  • Krussel & Smith in 1999 and 2002 reiterates what we’ve all learned – “patient heads will accumulate wealth and while others will run their wealth down.” and their model accurately reflects wealth distribution in the US. “The real promise of the Krusell-Smith model and related formulations, I think, will be in the study of the relation of policies that reduce the impact of risk by reducing the variance of shocks (like aggregate stabilization policies) to those that act by reallocating risks (like social insurance policies). Traditionally, these two kinds of policies have been studied by different economists, using unrelated models and different data sets. But both appear explicitly in the models I have reviewed here, and it is clear that it will soon be possible to provide a unified analysis of their costs and benefits.”
  • Conclusions: “If business cycles were simply efficient responses of quantities and prices to unpredictable shifts in technology and preferences, there would be no need for distinct stabilization or demand management policies and certainly no point to such legislation as the Employment Act of 1946. If, on the other hand, rigidities of some kind prevent the economy from reacting efficiently to nominal or real shocks, or both, there is a need to design suitable policies and to assess their performance. In my opinion, this is the case: I think the stability of monetary aggregates and nominal spending in the postwar United States is a major reason for the stability of aggregate production and consumption during these years, relative to the experience of the interwar period and the contemporary experience of other economies. If so, this stability must be seen in part as an achievement of the economists, Keynesian and monetarist, who guided economic policy over these years. The question I have addressed in this lecture is whether stabilization policies that go beyond the general stabilization of spending that characterizes the last 50 years, whatever form they might take, promise important increases in welfare. The answer to this question is No: The potential gains from improved stabilization policies are on the order of hundredths of a percent of consumption, perhaps two orders of magnitude smaller than the potential benefits of available “supply-side” fiscal reforms.”