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Summers, “Some Skeptical Observations on Real Business Cycle Theory”

BLUF:

This is a critique of the Prescott paper “Theory Ahead of Business Cycle Measurement”.

Notes:

Summers says “Extremely bad theories can predict remarkably well” with regard to Prescott’s model. (made me think of the Friedman “As if”). Basically he says that Prescott’s theory mimics the actual economy, but that doesn’t make it right.

He has 4 primary areas of criticism:

1) Prescott uses bad parameters. Summers’s review of the economic literature doesn’t lead to same conclusion about the parameters Prescott uses. E.g., he criticizes Prescott’s selection of the real interest rate to be 4%.

a. Disagrees strongly with Prescott’s assertion that a major factor in business cycles is the intertemporal elasticity of labor.

2) Prescott does not have empirical evidence of actual technological shocks that supposedly cause the business cycles.

a. Hard to find large technological shocks.

b. Best example of a large technological shock is the 1973 oil embargo. Summers quotes a study that says the energy crisis did not significantly impact labor productitivity.

c. Summers says that firms “hoard” labor during downturns. Hoarding labor means firms continue to employ workers even when the business cycle does not require the additional labor.

3) Prescott’s model does not include prices. “I simply do not understand how an economic model can be said to have been tested without price data.”

4) Prescott fails to address “exchange failures”. Summers says that a main characteristic of depressions is a “breakdown of the exchange mechanism” – meaning people have labor they are willing to trade for goods, but for some reason, they are not able to engage in trade. Concluding criticism is that economists are better at predicting the actions of individuals, but cannot predict equilibria when heterogenous individuals interact.

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