The Nobel Prize Goes to Robert Hall and Michael Woodford
Twenty-five years ago Tyler told me he thought Robert Hall should win the Nobel. He has been a contender for so long today’s award was a surprise! Hall has an unusual number of unexpectedly creative papers. His best known is on consumption.
Start with the textbook Keynesian model: Y = C + I + G + NX. Consumption is the biggest piece of Y and it also depends on Y, so C and Y have to be solved together. The consumption function was the engine of the Keynesian multiplier. The simplest version was C = a + bYd, where Yd is disposable income. Economists estimated b, forecast Y and used the forecast to predict C. Get b, the marginal propensity to consume (MPC), wrong and you get fiscal policy wrong; so a lot of work went into estimating the MPC.
Hall began instead with Milton Friedman’s permanent income hypothesis. Consumption today should depend not just on today’s income but on a consumer’s expected lifetime or permanent income. Hall added rational expectations, so people estimate their permanent income using everything they know. Many economists already accepted both ideas but Hall showed that together they imply something surprising. Consumption should follow a random walk!
Suppose you learn today that you will get a large, permanent raise starting next January. If you can save and borrow, you should start spending more today. When January’s bigger paycheck arrives, it isn’t news. You already knew it was coming.
So information that predicts your income should not predict changes in your consumption. Expected changes in income are already built into your spending plans, and only surprises cause revisions. In the simplest case (quadratic utility, free borrowing and saving, and an interest rate that just offsets impatience) the theory gives
Et(Ct+1 − Ct) = 0
Given what you know today, your best guess for the change in consumption is zero. Consumption moves only on news. Past income or any other variable shouldn’t help predict tomorrow’s consumption once you know today’s consumption.
The key point is that Hall’s test didn’t need a model of how people forecast income. The old consumption functions used things like a distributed lag on past income as a stand-in for expected future income. Hall asked a different question: does anything known today predict the change in consumption tomorrow? He found that the theory was surprisingly correct! Consumption looks like a random walk. Changes in consumption are unpredictable. Later work found consumption somewhat more predictable than Hall’s strict version allows, but the random walk became the benchmark everyone measures deviations from.
The methodological change was enormous. Instead of estimating a relationship between income and spending, economists could test restrictions implied by forward-looking choice. John Cochrane’s account of learning macroeconomics at Chicago describes how deeply Hall’s approach entered the profession’s way of thinking.
This is Hall’s most famous paper but what makes Hall interesting is the number of papers he wrote on very different topics.
Hall was part of the New Monetary Economics–Tyler with Randall Krozner wrote the book on this (alas hard to get) and see also our podcast. Hall’s contribution was a proposal for a commodity standard but not a gold or silver standard. Under a gold standard the price level moves with the relative price of gold, which swings around a lot. Hall’s alternative was to define the dollar as a fixed bundle of ammonium nitrate, copper, aluminum and plywood which he called the ANCAP standard. He chose those four because a price index of the bundle had tracked the CPI closely since the war, so pegging the dollar to the bundle would have come close to stabilizing the cost of living. He didn’t want the government stockpiling fertilizer and plywood. Private arbitrage would keep paper dollars tied to the basket. Hall offered it more as an exploration of what a commodity standard could do than as a policy he was campaigning for. Tyler has said nice things about it. And yes, ANCAP also abbreviates anarcho-capitalism. I assume that’s a coincidence.
Hall’s most famous policy idea is the flat tax, written with Alvin Rabushka at Hoover. Workers pay a single rate on wages above a generous family allowance. Businesses pay the same rate on revenue minus wages, minus purchases from other firms, minus investment, which is expensed immediately. Interest, dividends and capital gains go untaxed at the household level because the business has already paid. Add it up and you have a consumption tax, a VAT that lets workers deduct an allowance so the system keeps some progressivity. Most households could file on a postcard.
Flat tax bills appeared in Congress through the 1980s and 1990s and Steve Forbes ran on it in 1996 and 2000 but we never passed a flat tax. The idea did shape the Tax Reform Act of 1986, which cut rates and broadened the base, but the mortgage interest deduction, the charitable deduction and every other carve-out had a constituency, and the constituencies won. Public choice explains this one pretty well.
Abroad, however, the flat tax took off. Estonia went first in 1994. Russia adopted a 13 percent flat tax in 2001. Slovakia, Georgia, Romania, Bulgaria and a long list of others followed. Post-communist countries were building tax systems from scratch, without decades of entrenched deductions, and with lots of evasion that a simple low rate could reduce. Rabushka keeps the flags of about thirty countries in his Hoover office, although some later backed away.
Most of the foreign versions were flat-rate income taxes. The Hall-Rabushka plan exempted saving and investment, which makes it a consumption tax, and few countries adopted that part. Estonia came closest. It eventually stopped taxing corporate profits until they were paid out as dividends, which is the Hall-Rabushka logic applied to the business side.
Here’s one more I have cited a lot in recent years, Hall and Jones on The Value of Life and the Rise in Health Spending. Hall and Charles Jones offered a strikingly different perspective on rising health care expenditures. Most observers see health care consuming a growing share of GDP and conclude that something has gone wrong. Hall and Jones argued that it might be exactly what we should expect from growing prosperity. Here’s the simple argument. As we become richer, the marginal value of goods and services declines; another car or another vacation matters less, but another year of life becomes more valuable. Indeed, the more goods and services you have already the more valuable another year of life becomes! It’s better to live more, the richer you are. Thus, their model suggested that it could be optimal to spend more than 30% of GDP on health care by 2050. The United States is the world’s richest large country, why shouldn’t it spend a large share of GDP on enjoying those riches for more years?