Summers uses Prescott’s “Theory Ahead of Business Cycle Measurement,” to examine the state of Business Cycle theory. He points out that Prescott’s paper is brilliant in highlighting the appeal of real business cycle theories and making clear the assumptions they require. He does say that Prescott does not make much effort at caution in judging the potential of the real business cycle paradigm. He does agree that theory is now ahead of business cycle measurement because the measurement techniques do not exist that could adequately test the theories that are now available. He does use Ptolemaic astronomy and Lamarckian biology to point out that just because a theory can approximately mimic any given set of facts, does not mean that it is anywhere close to being accurate. He then moves on to four areas which are not persuasive enough in Prescott’s argument.
The first area in question is if the parameters of Prescott’s theory are correct. Summers claims that the well-established microeconomic and long-run information the model is based on is not sustainable. He claims that Prescott’s measurement of household time devoted to market activities is closer to 1/6 than 1/3 and has found no evidence to support Prescott’s claim. He also found the real interest rate to be closer to 1 percent as opposed to Prescott’s estimation of 4 percent. He also claims that Prescott’s assumption of intertemporal elasticity of substitution in labor supply, which is central to his model, has no evidence to support it. He claims that Prescott’s claims to be securely tied down in growth and micro observations are a gross overstatement.
His second problem is the lack of evidence to support the “technological shocks” Prescott speaks of. Summers says this is a critical point because the “technological shocks” in Prescott’s theory are the only thing that fluctuate the business cycle. Summers claims that Prescott’s measurements of the technological shocks are actually more along the lines of labor hoarding and other behavior not allowed in Prescott’s model. He says it is hard to find direct evidence of technological shocks. He also shows that while technological shocks leading to changes in total factor productivity are hard to find, other explanations are easy to support. He shows one example that “a sizeable portion of swings in productivity over the business cycle is the result of firms’ decisions to hoard labor.
Next he moves on to criticize the price-free economic analysis which Prescott seems to practice. He says by leaving out the price data, Prescott is free to account for other quantities. However, this makes it impossible to distinguish supply from demand shocks and this type of analysis would be ignored by most hard-headed economists. He claims that there are no reasons to support any of the findings on price effects predicted by Prescott’s model because they are not endogenous to it. He makes it clear that without price-levels incorporated into the model, cyclical fluctuations are very difficult to observe and the results are highly suspect.
His fourth and final fundamental criticism of Prescott’s work is that it ignores the breakdowns in exchanges mechanisms that are most certainly fundamental factors in cyclical fluctuations. He points out that cyclical fluctuations cannot be limited to movements in intertemporal substitution and productivity shocks especially given that total factor productivity has increased more than twice as rapidly in Europe as in the United States. He agrees that the Keynesian approach of saying that prices are rigid is not satisfactory but that leaving it out altogether is not the solution.