Priorities, people!

In my Macroeconomic Theory class, I sometimes have the students read a lecture by Robert Lucas, "Macroeconomic priorities". It is exemplary in the elegance of the analytical tools applied to the questions at hand. It is also cautionary in the way that Lucas overlooks some crucial elements of reality. When you bring those back into the picture, you do indeed learn something about what our macroeconomic priorities should be, it's just that they're not the ones that Lucas is promoting.

There are often said to be two basic issues in macroeconomics: business cycles and long-run growth. The argument in the lecture is that the gains to be had from further smoothing of the business cycle are quite small, while taxing and spending policies that promote growth would have a large, positive impact.

Lucas opens:

Macroeconomics was born as a distinct field in the 1940's, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades. (p. 1; emphasis added)

In fairness to Lucas, he was writing in 2002/3, when lots of people shared his notion that we already knew how to prevent depressions. But it's also fair to point out that in 2009 Lucas was arguing mockingly against efforts to apply what we knew about how to prevent a depression. We skirted the precipice after the financial meltdown of 2008, but it was no thanks to Lucas.

Lucas's first argument for the unimportance of business-cycle smoothing is based on seeing the whole economy as a single household. On the chart below, the squiggly line shows real GDP, while the smoother line shows potential real GDP--this is essentially an estimate of what our GDP would be if the business cycle were being perfectly smoothed out, and so the difference between the actual (squiggly) line and the potential is a measure of the imperfection of our short-term macroeconomic policy.

Data from research.stlouisfed.org

Lucas in effect says, Imagine that the blue line is the actual path of your income; How much would you pay to have your income follow the smoothed, red line instead of the squiggly, blue one? His quite reasonable answer is: Very, very little. He makes the further reasonable observation that it's unrealistic to think that we could actually get all the way to the red line. Let's say we can only eliminate a quarter of the wiggliness; the benefit of such business-cycle management is similarly reduced compared to a perfect smoothing.

It may occur to you that this overlooks a key fact: recessions fall unevenly on different people. Some are relatively unaffected, some actually prosper, and those who lose their jobs obviously suffer a great deal. Lucas acknowledges that as well, but the way he brings it in entirely misses the reality of uenmployment affects people.

There is an implicit assumption that the effect of unemployment is adequately captured by the mathematical utility functions used in the studies he cites. How are we measuring the loss of well-being from high foreclosure rates? How are we incorporating the psychological impact of being unemployed for a long time? How do you figure in the increase in the rate of suicide? On the plus side, a recession seems to reduce the rate of divorce, but it's only partly because couples turn to each other in hard times and realize how important their union is; the other factor is that a recession makes it hard for people to afford the cash costs associated with a divorce, while it does increase the stresses on their marriage.

In fairness to Lucas, he was writing before the Great Recession that started in late 2007, and the associated phenomenon of several million people being unemployed six months or more, and the unusually high foreclosure rates we've seen. But also in fairness, bad social effects of recessions are nothing new, and the recessions of 1991-92 and 2001 were characterized by very slow recovery in the job market, so there was plenty of opportunity to have observed that the negative effects of recessions may not be adequately captured in mathematical utility functions.

Also,

These calculations are sensitive--especially at the poor end of the distribution--to what is assumed about the incomes of unemployed people. Krusell and Smith calibrate this, roughly, to current U.S. unemployment insurance replacement rates. If one were estimating the costs of the depression of the 1930's, before the current welfare system was in place, lower rates would be used and the cost estimates would increase sharply. (p. 10)

So even if he's going to argue against the importance of doing more to smooth out business cycles, it seems he should be arguing against a reduction of the social insurance system, or else smoothing out business cycles would again (in his scheme) become a priority. Maybe he's doing that, but it's not what he's known for.

To sum up: Lucas argues that short-run fluctuations shouldn't concern us because the gains from doing a better job with them are small. Now to turn to question of the long run.

His case there can be outlined in the following steps:

1. (Empirical observation) Output in France is about 30% less per adult than it is in the U.S.
2. (Empirical observation) Labor input per adult is less in France than in the U.S.
3. (Basic macro theory) Higher labor productivity comes from increased and improved capital.
4. (Basic macro theory) Increased and improved capital comes from investment.
5. (Basic macro theory) Investment is funded out of savings.
6. (Basic macro theory) Savings comes from output.
7. (Simple logic) If there's more output, there can be a greater quantity of saving.
8. (Basic micro theory) If taxes are lower, there's greater incentive to work.
9. (Basic micro theory) If fewer things are provided free of charge, there's greater incentive to work (and if those things involve the future, like your retirement or your kids' college costs, there's greater incentive to save).
10. (Simple logic) If France were to cut taxes and balance that with a reduction in things the state provides, people would work more, leading to more output, and they'd save more, leading to more investment, leading over time to more and better capital, increasing their productivity, increasing output still more, which would increase the quantity of savings, enabling still greater investment ...   In other words:

Where to begin? How about with those first two items, which I kind of elided by saying that French labor input is "less". More specifically, to quote from Lucas:

Production per adult in France is about 70 percent of production per adult in the United States. Edward C. Prescott (2002) observes that hours worked per adult in France, measured as a fraction of available hours, are also about 70 percent of the comparable U.S. figure. (p. 2)

Which implies that output per hour in France is just about the same as output per hour in the U.S. The logic of Lucas's argument is that France is behind the U.S. because they don't have enough capital, or good enough technology, which they could have if they worked harder and saved and invested. But if their productivity per hour is already as high as ours, what was the problem again?

There is still the issue of why French labor input is 70% lower than ours. Part of it is unemployment: in 2002, when Lucas was writing this article, the unemployment rate was 8.9% in France compared to 5.8% in the US, and the difference had been bigger in the late 1990s. But a serious examination of the two countries' different unemployment rates would encompass, oh, I don't know, immigration policy and the incorporation of immigrants into society, deindustrialization, the impact of several years of high energy prices globally, the rise of China and India as industrail powers, ... Or, or, or, we could just imply, "High unemployment must be the result of high taxation," and leave it at that.

And then there are the vacations. According to Wikipedia, France has a statutory requirement of 5 weeks paid vacation, while the U.S. has none. One possibility is that the French people are oppressed and long to be free of the requirement to not work for 5 weeks a year. Another possibility is that they have different ... what's the word? Oh yeah: priorities.

Of course, as mentioned earlier, it's not simply about cutting taxes, because doing that by itself would lead to large government deficits. So:

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. Think of elementary schooling or day care. (p. 3; emphasis added)

Yes, let's think about those things, and why not throw in health insurance? Sure, if the government paid less for those things, people would buy them on their own, to a considerable extent, but rich and poor would buy different quantities. (With health insurance, the U.S. experience suggests that many people would buy zero.) To some extent, people probably already do buy some of this stuff on their own, with the rich supplementing what the state provides, or substituting entirely (e.g., sending their kids to private school). Still, reducing or eliminating the state's role would widen the gulf between rich and poor in terms of access to education, day care, health care, ...

The French system ensures that lower-income households have access to some socially-chosen minimum. Perhaps this puts a drag on long-term growth, though even that is not necessarily true: having poorly educated and ill people isn't great for growth either. But for the sake of argument, let's grant Lucas's implication that the French economy would be growing faster if the government reduced its expenditure on these things. Would it be worth it?

I'll just note that France is not a poor country. They're ensuring a minimum standard of education and health for members of the community. If you're rich, that isn't a stupid thing to do with your wealth. You don't have to do it, but you might choose to. And whether you made that choice would depend on your ... Damn! I keep forgetting the word. Oh right: priorities.

If the French on the whole like the arrangement of high taxes, universal access to some basic social services, and a GDP that is lower than otherwise (though not at all low by world standards), then why do we think that there's even a problem? Does Lucas know that France is a democracy?

Having looked at the issue of putting a floor under people's access to key services, we're next to the broader issue of equity.  Looking at the U.S. the first three quintiles of households have seen no gains in real household income since 1995. That's 60% of households in the country whose income has basically stagnated for almost two decades. The fourth quintile (better off than 60% of households, not as well off as the richest 20%) has stagnated since 1997.

 

Upper boundaries of quintiles; lower boundary of top 5%. Data from Table H1, at http://www.census.gov/hhes/www/income/data/historical/household/.

Over that same period, real GDP per capita has increased by 25%. What exactly is the point of higher GDP if it's not benefiting 80% of the people in your country? Why isn't income distribution a priority?

And then there are environmental questions. I'm in the small camp that things that access to resources is a key factor in economic performance, and that the economy's basic functioning is having really serious effects on our environment. (An exception to the general neglect of these questions in macro is Farley et al., "Monetary and fiscal policies for a finite planet." I don't agree with all of their conclusions, but I have no quarel with their framing of the problem.)

Stepping back, we need to remind ourselves that the economy should be the servant, not the master. Lucas falls into the all-too-common trap of "economism," treating the economy as a thing in its own right, that needs to prosper independently of whether the people in the economy are prospering. Ultimately, the only reason to care about the economy is to the extent that it contributes to or impedes a high quality of life.

In other words, we can't think sensibly about what constitutes a good economy until we know what it is we want our economy to accomplish.

We need to start with non-economic priorities before we talk about our economic priorities.