A Comment on Edward Prescott's "5 Macroeconomic Myths"

The eminent economist Edward Prescott has written an interesting opinion piece in today's Wall Street Journal. In it he argues that the economic position of the U.S. is 'fundamentally sound', though the reason for this is unstated, unless you include the idea that since the economy is composed of 'millions of people making billions of decisions every day to improve their lives, the lives of their families and the health of their businesses' as a reason why there can never be a recession. He then goes on to identify the following 'macroeconomic myths':

1. Monetary policy causes booms and busts.
2. GDP growth was extraordinary in the 1990s.
3. Americans don't save.
4. The U.S. government debt is big.
5. Government debt is a burden on our grandchildren.

My comments on each point are as follows.

1. Probably the two most influential economists who would differ with this assessment would be J.M. Keynes and Milton Friedman. This is to say, across the ideological spectrum, economists agree that monetary policy, though it is not the most significant variable in economic growth and contraction, it does play a role. Particularly, when monetary policy contracts during a recession, as is often the case in U.S. history, when a contracting economy ended a spree of bank expansion, leading to an immediate contraction of the money supply and consequent contraction of aggregate demand. A statement like this makes me wonder if Dr. Prescott believes that booms and busts occur at all.

2. I agree that GDP growth was not extraordinary during the 1990s, a point which is nicely made by Robert Pollin of the Political Economy Research Institute in his 2005 book Contours of Descent, in my view one of the best books about the 1990s economy.

3. Americans have clearly gone through a sea change with regard to their attitudes about saving. To repeat the tired notion that Americans are simply responding to an increase in the value of their assets seems a bit naive, when much of these assets -- especially stocks and real estate, about 75% of total household wealth -- are significantly overvalued. Indeed, according to the Financial Markets Center, the years 2000-2002 are some of the worst years for household wealth since 1950, with net worth declining 1.7%, 2.4%, and 3.9% respectively. Dr. Prescott says this myth is due to a misconceived idea about what it means to save. I'm curious as to what his definition of savings is. Mine would be disposable income minus consumption. With this definition, an increase in asset values is hardly relevant. Especially when the assets in question are notoriously illiquid, as in the case of real estate. Of course, we should also not overlook the point that wealth is quite unequally distributed in the U.S., with the top 1% holding greater assets than the bottom 90% of Americans.

4. U.S. government debt is not big, claims Dr. Prescott, arguing that we should only count privately-held debt in our tabulations. Why is this, exactly? I fail to see how it matters who holds the debt. If the Federal Reserve or other branches of government hold debt, does anyone think they'd be fine with the Federal government declaring their assets null and void? The U.S. government's public debt is, in fact, big: $8,655 billion. Just the interest on it alone was a crushing sum of $354 billion last year. Were we to pay off the principal, it would require additional payments of $172 billion for 50 years. That sounds big to me.

Dr. Prescott writes: "Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. This assumes 1% population growth, 2% productivity growth, 4% real after-tax return on investments, and that people work to age 63 and live to age 85. Currently, privately held public debt is about 0.3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt."

His analysis rests on the supposition that public debt is always undertaken as a productive investment, that will enhance the welfare of future generations. While nothing is impossible, it's almost laughable to characterize the spending of the Federal government thusly. How exactly does the $230 bil in appropriations for the war in Iraq going to help future generations?

I thank Dr. Prescott for a provocative essay on the state of the economy, but I wonder if he's looking at the same U.S. economy that I am.