Prosperity and Depression

Abstract

Prosperity and depression are relative concepts. Today both France and Japan are depressed relative to the United States; equivalently, the United States is prosperous relative to these countries. I say these countries are depressed relative to the United States because their output per working-age person is 30 percent less than the U.S. level. An interesting and important policy question is: Why are these countries depressed? The answers for these two countries turn out to be very different. The United States is prosperous relative to France because the U.S. intratemporal tax wedge that distorts the trade-off between consumption and leisure is much smaller than the French wedge. I will show that, if France modified its intratemporal tax wedge so that its value was the same as the U.S. value, French welfare in consumption equivalents would increase by 19 percent. Consumption would have to increase by 19 percent now and in all future periods to achieve as large a welfare gain as that resulting from this tax reform. The United States is prosperous relative to Japan because production efficiency is higher in the United States. In the United States, total factor productivity is approximately 20 percent higher than in Japan. If Japan suddenly became as efficient in production as the United States, its welfare gain in consumption equivalents would be 39 percent. Equally interesting and important are big changes over time in relative output (per working-age person) across countries. Why are New Zealand’s and Switzerland’s economies depressed by over 30 percent relative to their 1970 trend-corrected levels? Both of these countries have small populations, but depressions are not restricted to small countries. Japan, with its 125 million people, is now depressed by 20 percent relative to its 1991 trend-corrected level. On the prosperity side, why are Ireland and South Korea so prosperous now relative to their 1970 trend-corrected levels? This lecture is concerned primarily with big international differences among relatively rich industrial countries and changes in these differences over time. The countries that receive primary attention all have market economies and healthy, well-educated populations. In the countries considered, the variations in aggregate output per working-age person are large, and reasonably good measures of the factor inputs are available. This permits, in many cases, the identification of the change in policy or the difference in policy that gave rise to prosperity or depression. This is in contrast to business-cycle theory, which provides little guidance to policy except for the important policy implication that a stabilization effort will have either no effect or a perverse effect. The output variations studied and analyzed in this lecture are big: an order of magnitude larger than the much-studied business-cycle fluctuations. The variations studied, however, are an order of magnitude smaller than the muchstudied differences between the richest and poorest countries. Surprisingly, only recently have depressions been systematically studied from the perspective of growth theory, which is the theory used * University of Minnesota and Federal Reserve Bank of Minneapolis. I thank my colleagues at the University of Minnesota and the Federal Reserve Bank of Minneapolis for helpful discussions and comments. In particular, I thank Tim Kehoe, Ellen McGrattan, and Nancy Stokey for their help. I also thank Martin Weale and Franck Portier for providing some British and French tax information used in this lecture. Thanks also go to Sami Alpanda and James MacGee for research assistance and helpful discussions. This lecture draws heavily on collaborative research with Fumio Hayashi. I thank the Economic and Social Research Institute, Cabinet Office, Government of Japan and the U.S. National Science Foundation for financial support. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.