Receive the Bulldog Edition


Economic Blogosphere

Economic Journalists


economicprincipals.com banner

January 19, 2003
David Warsh, Proprietor


| contents |

What Next?

For nearly thirty years, the University of Chicago’s Robert Lucas has been a reliable guide to What Comes Next in Economics? Because the research future rarely has been obvious, he takes a little getting used to.

With a series of technical papers in the early 1970s, Lucas operationalized general equilibrium analysis, introduced expectations to macroeconomic analysis and changed the way we think about policy evaluation.

With his Marshall lectures in 1985, he redirected economists’ attention to problems of the growth of the wealth of nations — and away from their preoccupation with the business cycle.

 

What are the chances that he has lost his touch?

In his presidential¬†address to the American Economic Association earlier this month, Lucas declared that macroeconomics had succeeded in its original intent — as an intellectual response to the Great Depression.

Now it was ready for something else.

“Its central problem of depression-prevention has been solved, and has in fact been solved for many decades.”

“There remain important gains in welfare from better fiscal policies,” he said, “but these are gains from providing people with better incentives to work and save, not from better fine-tuning of spending flows.”

Lucas’ argument took the form of a master class in quantitative policy evaluation. By the time he had finished, he had lost as much as a third of his audience to the cocktail parties that were beginning elsewhere.

But for those who like this sort of thing, Lucas provided an exhilarating sketch of the state of current knowledge of the sources of business cycle risk, their potential costs, their distributional effects, and the benefits of stabilization policy.

The calculation of welfare gains and losses is a well-established tradition in modern macro, originating in a back-of-the-envelope exercise by Martin Bailey, who in 1956 estimated the welfare cost of inflationary finance to be around 1 percent of spending per year.

A couple of years ago, Lucas replicated Baily’s results, using the latest tools and techniques. He showed that for rates of inflation as high at 200 percent — not unheard-of in Latin American economies in the recent past — the cost could be as much as 7 percent on annual income, a serious problem by any standard.

But with prices relatively stable from year to year in the industrial democracies, the gains from better monetary policy have been realized.

What about the business cycle? The centerpiece of Lucas’ lecture is a thought-experiment using the standard welfare-triangle approach in a stripped-down model in order to assess the potential gains from eliminating variability altogether

He concludes that a representative consumer would be willing to trade barely one-half of one-tenth-of one percent of consumption — that’s .0005 of the whole — in order to be completely insulated from the ups and downs of the business cycle.

Then, noting that the business cycle is much harder on the poor and the young than on the well-established and the well-to-do, he surveys various models that permit detailed consideration of the distributional effects of unemployment.

Such studies of cross-section and panel data are still in their infancy, he says. But they promise a much improved understanding of the relationship between stabilization policies and the social insurance programs, including unemployment insurance, that are intended to protect against their failures.

It is possible to disagree with Lucas’ assumption that the economy can’t be brought consistently closer to its potential output by sophisticated management. And among his listeners, many did.

With preliminary signs that the US economy contracted slightly in the fourth quarter of 2002, advocates of stimulus and architects of unemployment insurance programs still have a large constituency.

 

But Lucas’ sophisticated calculations confirm what common sense suggests — that a shallow recession every ten years is pretty satisfactory business-cycle management. Whoever gets the credit for the stability of spending, production and consumption in the sixty years since the end of World War II, Keynesians or monetarists, the record is impressive, at least in the United States.

So what’s next to argue about?

According to Lucas, it’s “excess burden.” Now that the stabilization problem is largely solved, he says, reforms that would lead to further gains in economic performance — on the order of a hundred times greater than the benefits within easy reach of more fine-tuning — should be on the agenda..

Such as what? Well, tax reform is one familiar feature of economists’ wish-lists. Eliminating structures that penalize capital accumulation and work effort could produce gains amounting to sizeable fractions of income, says Lucas. Getting citizens to save more could produce big gains.

So could the rearrangement of some of the more stifling economic arrangements of the mixed economy as they emerged in the 20th century, especially in Europe — the government provision of goods that most people would buy anyway, financed by distorting taxes. “Think of elementary schooling or day care,” he said, meaning privatize them.

Thus if the 20th century was the century in which monetary policy finally came to be pretty well understood, Lucas says, the central problem of the 21st century will be coming to terms with long-term fiscal policy. It seems like a pretty good guess.

| contents |


Skim past columns here.


Support Economic Principals by subscribing to its bulldog edition—receive the weekly via email a day before it is posted on the Web, and, as well, a quarterly Report to Subscribers.

To reach the proprietor, ask a question about the website or report a problem email warsh@economicprincipals.com.