What Happens Next?

I’m not sure. My version of the real business cycle model (some of my academic papers on it are here and here, and I began applying it to this recession about a year ago, such as here and here) does not give a definite answer, but it does drastically narrow the possibilities.

My model has no adverse productivity shocks, no shocks to capital markets (these variables just reaction to events in the labor market), no monetary policy, and no fiscal stimulus. Simply put: I view this as a one shock recession, and the labor market is ground zero for that shock.

One version of the model has a labor market distortion that gets progressively worse for two years, at which point it remains at that higher distortion forever. Specifically, the average marginal tax rate ultimately increases about 10-15 percentage points (more accurately, the after tax share is cut by 22 percent), but it takes 2 years for the full marginal tax rate hike to occur.

The model and data are shown below. Note that latest 12 months (4 quarters) of the data were not available when I first began writing about this model.

[APL is real GDP per hour worked — labor productivity — which in the model is in fixed proportions to the marginal product of labor]

The good news from this first scenario is that the labor market will stop getting worse in 2010 (ie, employment and hours will stop falling further below trend). The bad news is that aggregate hours will never return to that previous trend, even part way. Consumption will ultimately be further below trend than it is now.

I am still working on it, but I think there’s another version of the model that would fit the same data: the labor market gets even worse for a couple of more years, but eventually will be closer to the previous trend than we are now. The bad news from this second scenario is that the labor market will not stop getting worse until beyond 2010. The good news is that consumption and aggregate hours will eventually return to their previous trends, at least most of the way.

Either way, the inference I am making from consumption behavior — it has fallen a lot by historical standards, but far less than labor has fallen — is that the present value of lost labor is great, but much of that loss labor has not yet occurred. Whether the remaining lost labor is spread over the infinite future (the first scenario above), or concentrated in the next couple of years (the second scenario above), I do not know.

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About Casey B. Mulligan 76 Articles

Affiliation: University of Chicago

Casey B. Mulligan is a Professor in the Department of Economics. Mulligan first joined the University of Chicago in 1991 as a graduate student, and received his Ph.D. in Economics from the University of Chicago in 1993.

He has also served as a Visiting Professor teaching public economics at Harvard University, Clemson University, and Irving B. Harris Graduate School of Public Policy Studies at the University of Chicago.

Mulligan is author of the 1997 book Parental Priorities and Economic Inequality, which studies economic models of, and statistical evidence on, the intergenerational transmission of economic status. His recent research is concerned with capital and labor taxation, with particular emphasis on tax incidence and positive theories of public policy. His recent work includes Market Responses to the Panic of 2008 (a book-in-process with Chicago graduate student Luke Threinen) and published articles such as “Selection, Investment, and Women’s Relative Wages,” “Deadweight Costs and the Size of Government,” “Do Democracies have Different Public Policies than Nondemocracies?,” “The Extent of the Market and the Supply of Regulation,” “What do Aggregate Consumption Euler Equations Say about the Capital Income Tax Burden?,” and “Public Policies as Specification Errors.” Mulligan has reported on some of these results in the Chicago Tribune, the Chicago Sun-Times, the Wall Street Journal, and the New York Times.

He is affiliated with a number of professional organizations, including the National Bureau of Economic Research, the George J. Stigler Center for the Study of the Economy and the State, and the Population Research Center. He is also the recipient of numerous awards and fellowships, including those from the National Science Foundation, the Alfred P. Sloan Foundation, the Smith- Richardson Foundation, and the John M. Olin Foundation.

Visit: Supply and Demand (in that order)

1 Comment on What Happens Next?

  1. By not taking into account monetary policy you might as well be writing a fiction. What ever you are saying is completely meaningless.

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