Editorial
The 2004 Nobel Economics Prize
by Fred E. Foldvary, Senior EditorThe 'Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel' for 2004 was won by Edward Prescott and Finn Kydland. Prescott is a professor at Arizona State University, and Kydland, born in Norway, is a professor at Carneigie Mellon University in Pennsylvania.
They were recognized for their research in two related fields of economics, in which they worked together. The first field is about the predictability of economic policy. Their most influential article was, 'Rules Rather than Discretion: The Inconsistency of Optimal Plans,' written in 1977. They found that one way government policy makes the economy worse is when it is erratic and unpredictable. This increases uncertainty and reduces investment.
Governments pursue long-term and short-term goals. Suppose the monetary authority seeks price stability in the long run, but seeks to stimulate the economy in the short run. The central bank expands the money supply, but then when inflation increases, it reduces the rate of growth of money. So inflation goes up and down, and nobody can predict future inflation. Many businesses need to plan far ahead, and often make contracts that set the prices of goods to be delivered in the future. But if there is unexpected inflation, or if there is an unexpected tax increase, they end up losing money. This inhibits such contracts and reduces investment.
Kydland and Prescott's work shows how governments create economic trouble when they don't stick to a fixed policy rule. Short-term deviations as well as continuous changes, such as with tax rates, create long-run problems. Expectations about the future are important not just for individuals but also for the economy. Their policy conclusions were timely; there was both high inflation and high unemployment during the 1970s, and because of the bad experience and findings by Kydland and Prescott, central bankers put into effect better, more consistent rules, which reduced inflation. Unfortunately, the same is not the case with fiscal policy, as for example the U.S. federal government changes income tax rates almost every year.
Their other field was the business cycle. From the 1930s to the 1970s, the dominant school of macroeconomic thought was demand-side Keynesian doctrine, which said that depressions were caused by a lack of aggregate (overall) demand. The Keynesian prescription was for government to stimulate demand with more spending and the expansion of money. But when government did that during the 1970s, it did not work. There was stagflation, both high inflation and high unemployment, which according to Keynesian doctrine, should not happen.
Kydland and Prescott came up with a different theory of the business cycle, focusing on the supply side. Called 'real business cycle' theory, they said that changes in productivity drove the business cycle, influenced by supply shocks such as a sudden increase in the price of oil. When technological change occurs unevenly, it creates fluctuations in output, as happened during the technology boom of 1995-1999. These causes are real, physical, changes, not just changes in the amount of money circulating.
Many economists believe that while supply shocks and technological booms cause economy-wide fluctuations, they do not explain the regularity of economic cycles that have occurred since the early 1800s. Also, technology and capital-goods booms are often subsidized by government, either directly as with the canals and railroad boom in the US during the 1800s, or in the form of artificially cheap credit, when the government expands the money supply.
Random supply shocks, whether positive from technology or negative from input-price increases, create random fluctuations rather than cycles that have a time regularity. Major depressions since the early 1800s have occurred every 18 years, with an exception for the interruption caused by World War II. Real estate cycles correlate with this major business cycle, which indicates that technology booms may make their mark mainly by real-estate construction and land purchases, fueled by the expansion of money (see reference below). Thus, the ultimate and basic causes of the business cycle are credit expansion and real-estate speculative booms, although there are indeed booms and busts that are technology-based, as is the case with the 1990s boom and subsequent bust of 2000-2001, made much worse by the shock of 9/11.
A truly free market, where money is supplied by private firms and where taxes are replaced by a tap on land rent at a fixed rate, would eliminate policy time inconsistencies and also eliminate the monetary and real causes of the business cycle.
Prescott and Kydland have contributed important insights into economic policy, and they were an excellent choice for the 2004 Nobel Prize in economics. Congratulations!
Reference
Fred Foldvary, "The Business Cycle: A Georgist-Austrian Synthesis." American Journal of Economics and Sociology 56 (4) (October 1997): 521-41.
Copyright 2004 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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