Research

From the causes of booms to the size of our debt: Dispelling seven macroeconomic myths

The U.S. government debt is massive — and growing out of control. Our debt is a burden on our grandchildren failing to decrease it today is selfish and myopic. Those are statements that most Americans have become accustomed to hearing. They're also two of seven widely propagated myths which 2004 Nobel Laureate and W. P.  Carey School professor of economics Edward Prescott sought to dispel in a recent presentation at the Economic Club of Phoenix.

2006-10-25

The U.S. government debt is massive — and growing out of control. Our debt is a burden on our grandchildren; failing to decrease it today is selfish and myopic. Those are statements that most Americans have become accustomed to hearing.

They're also two of seven widely propagated myths which 2004 Nobel Laureate and W. P. Carey School professor of economics Edward Prescott sought to dispel in a recent presentation at the Economic Club of Phoenix.

Myth 1: Alan Greenspan caused the economic boom in the 1990s

Former Council of Economic Advisors Chairman Gregory Mankiw said in 2002 that "No aspect of U.S. policy in the 1990s is more widely hailed as a success than monetary policy. Fed Chairman Alan Greenspan is often viewed as a miracle worker." According to Prescott, who also serves as a senior monetary advisor at the Minneapolis Federal Reserve Bank, statements like those fuel the myth that Greenspan's monetary policy led to the economic boom in the 1990s.

But if it wasn't monetary policy, then what drove the economic boom in the 1990s? To answer that question, Prescott and his colleague at the Minneapolis Fed, Senior Economist Ellen McGrattan, looked at the fundamentals that influence stock market value. In particular, they examined the value of corporations' productive assets, including tangible and intangible capital.

Intangible capital includes patents, brand names, processes, and clientele — anything of value that an organization creates but can't be touched. "In the 1990s, this intangible capital, particularly in the IT sector, really boomed," Prescott said. "Normally, intangible investment is about 3 percent of output. In the 1990s it was about 7 percent," he added.

Yet investment in intangible capital isn't captured by the national accounts — the traditional measure of investment and output — which only include physical capital investment. So in a period where intangible capital boomed but was not accounted for by traditional measures, modeled outcomes looked very different than actual outcomes.

But adding in the intangible investment component, the behavior of the U.S. economy in the 1990s is in striking conformity with theory. And the missing link — technology advances in producing intangible capital — was in fact the driver of the 1990s economic boom.

Total factor productivity (output per unit of input, including labor and capital) grew much more quickly for intangible capital in the 1990s than for goods and services. New scientific and technological discoveries occurred and they were exploited by smart entrepreneurs who developed many billion dollar companies for their new ideas. They weren't investing in heavy machinery and factories, but rather in creating new products.

And it was that increasing productivity of intangible capital that led to increasing investment in intangible capital, and that led to the boom of the 1990s. "The boom," Prescott said, "was due to those engineers and scientists that figured out new technologies, and business people that made things happen."

That Greenspan didn't precipitate the economic boom of the 1990s is not to say that he didn't do a good job, Prescott added. "He increased interest rates in order to choke off inflation, and that's the job of the central bank."

Myth 2: GDP growth was rapid in the 1990s

Looking at above-trend GDP growth historically, the economic expansion in the 1990s was actually relatively small compared to expansions in the 60s, 70s, and 80s, Prescott suggested. Between the first quarter of 1996 and the first quarter of 1999, for example, growth was 3.8 percent.

But between the fourth quarter of 1960 and the first quarter of 1966, growth was 12 percent. And between the fourth quarter of 1982 and the second quarter of 1989, growth was 9.7 percent. Prescott's message: it's important to look at data in its historical context to get the true picture.

Myth 3: The 1978-82 recession was caused by tight monetary policy

"Everybody says that former Fed Chairman Paul Volcker caused the 1978-82 recession with his tight money (high real Federal Funds rate) policies," suggested Prescott. But looking at the data historically, there is no consistent relationship between monetary policy and real economic activity.

"Between 1975 and 1980 monetary policy was very loose (the real Federal Funds rate was low)," Prescott said. At the same time, output trended upward until 1979, when it began a downward trend. Yet even though output began a downward trend in 1979, the Fed didn't significantly tighten monetary policy until 1981. Then, output continued its downward trend through 1982, when it began to climb again — even though monetary policy was still tight.

In the end, Prescott says, he doesn't see any relationship between the real economic activity and monetary policy during the 1975-85 period.

Myth 4: Americans don't save

"You hear a lot about not enough savings in this country," Prescott said. But in actuality, he suggested, we do save — and plenty. The problem is that the national accounts — traditional measures of savings and investment — do not include savings associated with the production of intangible capital. He proposed looking at total national economic wealth (which includes real estate, business tangible assets, government tangible assets, and business intangible assets).

"I don't do the national accounting to figure out how much you save," Prescott told the audience. "I look at how much wealth you have." Wealth includes capital gains. "Entrepreneurs go out and invest themselves in their business, which they should then be able to sell — yielding capital gains — if they're successful," he said.

Looking at the full picture — at economic wealth — Prescott said that we save roughly the same amount as we always have: about 5 times gross national product. "We're saving the right amount — the amount that theory says we should be saving," he said.

Myth 5: The U.S. government debt is big

Lately, media has been filled with rhetoric about the massive — and growing — federal debt. But when Prescott looks at privately held interest-bearing public debt relative to gross national income, he sees current levels that are quite similar to historic levels.

In World War II, debt relative to income peaked; it fell through 1973; rose again through 1993; decreased through 2002; then rose slightly since then. Still, current levels of privately held debt relative to income are similar to what they were in the 1960s, and are lower than they were in the 1980s and 1990s. Prescott's conclusion: from a historical perspective, the current U.S. government debt is not big.

Myth 6: Government debt is a burden on our grandchildren

In addition to hearing about how big the U.S. government debt is, we're also told about how our large debt will burden our grandchildren, that they'll be stuck footing our bill. But according to Prescott, not only is the U.S. government debt not relatively large, it's also not going to burden anybody. To the contrary, Prescott suggested that the current U.S. government debt is not big enough.

Assuming no population growth, 2 percent productivity growth, 4 percent after-tax return on investments, and that people work between the ages of 21 and 63 and live to be 85, Prescott says that the optimal amount of debt is about 2 times gross national income. Currently, privately held public debt is at about 0.3 times gross national income. In a sense, U.S. government debt is not that far from the appropriate amount.

Legally, Social Security promises are not government debt, but if these promises are treated as debt, total U.S. government debt is 1.6 times gross national income. Even then Prescott concludes we have too little debt. The problem, Prescott says, is that there are not enough productive assets — tangible and intangible capital like machinery, workers, and processes — to meet all of the savings that people must do for their retirements.

So why not have more productive assets? The rate of return on investment — creating more productive assets — decreases as the stock of these assets increases. That, Prescott says, leads to inefficiencies. Government debt, then, is a mechanism for people to better distribute their consumption over their lifetime.

Myth 7: U.S. economy is doing much better than the European economy

It's true, Prescott said, that the labor supply is depressed in Europe. "They have a problem and they understand that." But Europe's problems, Prescott suggests, are policy related. "Europe is as productive as the U.S.," Prescott said. "It's just that their tax rates are too high and as a result they work too little." Germany, France and Italy will follow the lead of the United Kingdom and Spain and cut their tax rates.

This will result in these countries catching up to the United States in terms of GDP per capita. Like Europe, per capita GDP in the U.S. has been roughly on trend since 1991, with the exception of the boom in the late 1990s. In Japan, in contrast, productivity stopped between 1992 and 2002. Prescott conjectures that this occurred because Japan's bureaucratic industrial banking complex subsidized inefficient businesses in this period.

"A firm will not make a needed investment to become more efficient if its competitors are subsidized. Because of the subsidies to competitors, there is not a return on this investment. The incentives are perverse," Prescott said. Many of the preconceptions behind Prescott's seven myths have to do with data that's not accurately measured or represented. The importance of unmeasured intangible capital in the 1990s is the best example.

Yet sometimes, the data tell one story while people tell another. To avoid falling into that trap, Prescott suggests that we do our own independent research. Though it may take some getting used to, he says, going to the Internet to look the numbers up ourselves is not as hard as it may appear.

Bottom line

• The economic boom in the 1990s was not caused by Fed Chairman Alan Greenspan's monetary policy, but by the increasing productivity of — and increasing investment in — intangible capital.
• Above-trend GDP growth in the 1990s was actually relatively small compared to other expansions in the 60s, 70s, and 80s.
• There's no relationship between monetary policy and real economic activity in the late 1970s and early 80s.
• Americans save the right amount.
• The current level of U.S. government debt is quite similar to historic levels of debt.
• The U.S. government debt is not big enough.
• The U.S. and European economies have been on trend since 1991, while the Japanese economy has declined quite dramatically.
• The best way to get an accurate picture of the economy is to investigate the data independently.

Economics Faculty