I'm here at the SED (Society for Economic Dynamics) meetings in Montreal. I love this city. The place is very liveable - great in the summer (though it's hot today), and I love the winter here too (that's a Canadian thing, or maybe memories of my grandfather pulling me around in a sled).
Yesterday afternoon, I attended this workshop at the Universite de Montreal (sorry, can't find the accents) on the financial crisis. In this, we got a familiar rehash of events during the crisis, but there were also some noteworthy goings-on.
1. Bob Hall reviewed the key features of the aggregate data in a useful way. Important points were: (i) In terms of the the components of GDP, the downturn is all in consumer durables and investment. It's important, I think, to remember that there are key sectoral aspects to the recession. One initial source of our problems was the poor incentive structure (in the US) that caused us to build more houses than we should have. The ensuing related problems in financial markets had much of their real impact in the markets for durables, where credit is important. (ii) Average labor productivity typically falls in a recession. This time it has not. (iii) An interesting set of labor market observations, which you can see on Rob Shimer's web page relate to the Beveridge curve, or the typical negative correlation between unemployment and vacancies. Since 2000, the data fall on what appears to be a stable Beveridge curve (though of course we know this relationship is no more structural than the Phillips curve). Since late 2009, however, the vacancy rate has been rising, but the unemployment rate has been stuck at just below 10%. For what it's worth, here is an anecdote consistent with these observations. What the data indicates is fundamental mismatch in the labor market, between the skills that firms want and the skills the unemployed have. There is long-run structural change going on in the US economy - including a shift from manufacturing to services, and a shift in demand from low-skilled to high-skilled labor. We're all aware, I think, of the increase in the wage gap that developed 30 or so years ago between college-educated workers and those with less education. The housing boom masked some of what was going on, as it absorbed a lot of low-skilled workers. With the collapse in housing construction, we're stuck with the fallout - what some would call structural unemployment - which is making the unemployment rate higher than it would otherwise be.
2. Narayana Kocherlakota reprised his proposal for "rescue bonds," which I discussed here. This is interesting, but for purely academic reasons. I don't think it has any practical merit, for reasons I discussed in the earlier piece. Lucas made a good point, which left Narayana sputtering a bit. The idea is that, in an economy with a great deal of government intervention, we seem to find externalities everywhere we look. Lucas's example (if my memory has not failed me entirely) concerns a diabetic living in Canada (I'm adding that) who is imposing an "externality" on society if he/she does not treat his/her diabetes - this will just increase health care costs for the rest of us. The fundamental problem, if there is one in this example, really has nothing to do with externalities. Now, the problems of financial regulation Narayana is thinking about have to do with basic frictions - private information and limited commitment. Beginning in the 1970s, economists developed what we now know as mechanism design theory to think about how resources should be allocated in economies with private information and limited commitment. In mechanism design theory, "externality" is not part of the language, and it's not a useful concept. If mechanism design has a problem, it's that it does not tell us how to implement the solution to the mechanism design problem. What is the government supposed to be doing, and what is the private sector supposed to be doing? How do we interpret this solution in terms of "markets" or "regulation?" Obviously we have a lot of work to do.
3. Ed Prescott did pathbreaking work in the economics profession, and his Nobel prize is well-deserved. His work with Finn Kydland made macroeonomists more quantitatively disciplined, and serves as a benchmark for most of the work done in macro in the last 30 years, including New Keynesian economics, models with financial frictions, and incomplete markets models. However, I doubt that there were any people in the room yesterday who took Ed seriously. Ed's key points were: 1. Monetary policy does not matter. 2. Financial factors are the symptoms, not the causes, of the recent downturn. 3. The recession was due to an Obama shock, i.e. labor supply fell because US workers anticipate higher future taxes.* Bob Hall suggested that this would require a Frisch labor supply elasticity of about 27, which seems ridiculous. However, Ed stuck to his guns and thus seemed - well, ridiculous. As a basic framework, the real business cycle model is obviously useful - you can't argue with a basic framework of preferences, endowments, technology, and optimal choice. I think we know by now, though, that financial factors have a lot to do with what we are measuring as TFP (total factor productivity). We certainly should not be listening to suggestions that central banks are irrelevant - these institutions can clearly reallocate resources in a big way when they want to.
*As a commenter pointed out, Prescott may have been talking about capital income taxes, though it was hard to tell. And, as Rody Manuelli pointed out, the labor supply story makes no sense in the context of Prescott economics anyway. In a Prescott world, we would substitute leisure intertemporally in response to higher future labor income tax rates - labor supply in the present would go up, not down.