The Current Downturn: Labor-leisure tradeoff or technological regress

Some views from an economist who is not “advancing the science”.

Reader Joseph commenting on the stimulus bills brings my attention the Cato ad, wherein several Nobel laureates write against a stimulus plan. Ed Prescott is the Nobel laureate who won for work on growth/macroeconomics, so attention must be paid! I looked a bit for his reasoning, and only found this quote from the East Valley Tribune:

“I don’t know why Obama said all economists agree on [the need for a stimulus bill],” Prescott said. “They don’t. If you go down to the third-tier schools, yes, but they’re not the people advancing the science.”

So, I think it’s worthwhile to infer why Prescott is against the bill. I will refer to his very influential 1986 paper “Theory ahead of business cycle measurement”:

Economic theory implies that, given the nature of the shocks to technology and people’s willingness and ability to intertemporally and intratemporally substitute, the economy will display fluctuations like those the U.S. economy displays. Theory predicts fluctuations in output of 5 percent and more from trend, with most of the fluctuation accounted for by variations in employment and virtually all the rest by the stochastic technology parameter. … Theory predicts that deviations [from trend] will display high serial correlation. In other words, theory predicts what is observed … .

The policy implication of this research is that costly efforts at stabilization are likely to be counterproductive. Economic fluctations are optimal responses to uncertainty in the rate of technological change … .

The paper lays out in a fairly straightforward fashion the logic. I highly recommend reading it. However, I think it useful to lay out the logic in a simplified manner, such as I would teach it in an intro macro course.

Let output be given by:

Yt = ztkt1-θn tθ

Where z is a technology parameter, or “shock”, k is capital, and n is labor.

Households optimize intertemporally, and both demand and supply jointly determine output (in the crudest Keynesian models — but not the neoclassical synthesis — output is demand determined). Output then only moves in response to changes in z, k and n.

k might change if the user cost of capital changes. n might change as workers decide to alter their labor-leisure tradeoff, perhaps in response to changes in the real interest rate (or perhaps, there is an exogenous change in preferences of leisure against labor). Alternatively, z has changed. Let me focus on this, since that has been a central parameter in real business cycle (RBC) models. In this interpreation, we have since September 2008 experienced substantial technological regress. What the exact nature of this technological regress is remains open to question. One could say that the financial system is part of technology, and we’ve forgotten how to overcome asymmetric information problems previously handled by a banking system combined with regulation. Or perhaps the trend rate of growth in technology has changed. Remember in the original Prescott paper, in order to match the time series pattern of deviation of output from the Hodrick-Prescott filtered data, the autoregressive parameter was set to near unity; but the trend was subsumed into the HP trend.

In this world, output is essentially always at potential (i.e., CBO estimated potential GDP shown in this post is just plain wrong). So government spending would of course be counterproductive, since it would waste resources. Further, in this interpretation, all the current and incipient rise in unemployment is an optimal response to changing relative prices and prospects for technology growth. Hence, Prescott’s anti-stimulus view is definitely internally consistent with his views on the way the world works, and I laud him for being internally consistent (a scarce commodity in this world). But it is important to understand exactly how he thinks the world works before taking his prescriptions to heart.

Now, taking a less extreme view, and allowing for some bigger deviations from potential (say due to irrational expectations, or learning, or some rigidities), one could interpret current events as follows (inspired by a graph in Chad Jones’ Macroeconomics textbook):


Figure 1: An interpretation of the current downturn. Bold line is actual (log) GDP, short dashed line is perceived and long dashed line actual log potential GDP.Here, what I think is a negative output gap is in reality a positive output gap, and in this case, a stimulus bill with spending and tax cut provisions only worsens the situation.

Now, as Jim has noted, technological frictions, say due to big changes in relative prices, could induce what looks like involuntary unemployment. And we’ve definitely seen changes in relative prices over the past few years. Hence, I don’t rule out an important role for technology, and maybe we can’t get to the pre-shock trajectory. But once one moves away from a model wherein one is always at full employment, then a role for countercyclical policy becomes plausible (note that Jim still thinks transfers to states, and infrastructure investment, makes sense. And I agree — if we could focus most of the spending on these items, and forego the tax cuts, I’d be even more in favor of the stimulus bills.) Nonetheless, I do think at least some of the decline in output in 2008Q4 apparently at a rate of 5% annualized (discussed here) is not attributable to a decline in potential GDP. I leave with a parting picture of the evolution of output over the last two years.


Figure 2: Log first difference of real GDP (blue) and log level of real GDP (red), SAAR, Ch.2000$. Source: BEA GDP NIPA release of 30 January 2009, and author’s calculations.

Originally published at Econbrowser and reproduced here with the author’s permission.

One Response to "The Current Downturn: Labor-leisure tradeoff or technological regress"

  1. wincent.tan   February 15, 2009 at 9:17 pm

    I agree there are a lot of leisure activities one can take up in singapore. Just count the number of singapore tourist attractions and you will know that Singapore ain’t that boring a place.