A lot of policy fiddling yields a truth worthy of Nobel prize

October 13, 2004|By Jay Hancock

THE economists who won a Nobel prize Monday did what economists often do: state the blindingly obvious in the form of algebra.

Finn E. Kydland and Edward C. Prescott argued that -- this is the English version -- the best solution to today's problems might not be the best solution tomorrow, but that frequent policy fiddling to reap short-term benefits can cause its own problems.

You or I, pointing this out to our spouse at dinner, will get, "Sure, hon. Pass the sprouts."

Kydland and Prescott got the Bank of Sweden Prize in Economics in Memory of Alfred Nobel, as it is officially known, plus $1.3 million to share. And perhaps they deserve it.

For what is blindingly obvious to most of us is not obvious to Congress, central banks and other policy-makers. By demonstrating their conclusions mathematically and by linking them to accepted theory, Kydland and Prescott influenced policy -- especially monetary policy -- and furnished intellectual ammo against the feel-good fix du jour.

Their work, which many economists believe is also relevant to taxes, disaster relief and a wide range of government policy, is implicitly conservative, in the best sense of the word.

It accounts for incentives and real-world behavior by consumers and businesses, and it demonstrates the virtues of stability, consistency and credibility.

Gold bugs and other hard-money fans: This Nobel's for you. Likewise, anybody worried about policy flip-flops over, say, estate taxes or Medicare. Or even North Korea.

The Royal Swedish Academy of Sciences, which awards the prize, also praised Prescott's and Kydland's work on how booms and busts can be induced not just by changes in demand but by new technologies or supply shortages. But their 1977 paper on policy consistency probably had more real-world effects.

Perhaps their greatest influence came among central banks such as the Federal Reserve, which try to control the money supply and short-term interest rates to maximize economic performance.

Prescott, of Arizona State University and the Federal Reserve Bank of Minneapolis, and Kydland, of Carnegie Mellon University in Pittsburgh, built on the work of Robert E. Lucas Jr., who won the economics Nobel in 1995.

Lucas changed economic theory with his "rational expectations" thesis, which says -- more common sense -- that people aren't dumb, that they change behavior in response to government policy and that they often produce outcomes opposite to what policy-makers want. (Low interest rates intended to spur growth might cause a stock-market bubble and then a crash, causing not growth but recession.)

Prescott and Kydland took it another step, looking at government decisions over time and how rational consumers and businesses respond.

While they argue for consistency, they also say policies aren't frozen in time and shouldn't be evaluated as such. One example they use is patents -- say, on environmentally friendly cars. If pollution were choking the country, traditional economic analysis might show that national welfare would be improved by patent protection and other incentives to spur development of green autos.

But after the cars were developed the same orthodox analysis might show that an "optimal" economic outcome would be obtained by revoking the patents to ensure the cars are widely and cheaply available.

Of course, any government that tried such a trick would be asking for trouble. Having rational expectations based on past government behavior, and knowing profits would be confiscated in the future, potential patent-holders wouldn't bother developing green cars at all.

Where's the economic optimization in that?

Prescott and Kydland also argued for consistent, rule-based regulation that gives government "credibility" and restricts its ability to alter policy.

Influenced by their work, several nations have built barriers between legislators and central banks in an effort to distance monetary policy from political whim. Their ideas live on in proposals by, among others, Fed Governor Ben Bernanke, to remove discretion from the Federal Reserve by tying it to an explicit "inflation target."

If there is a danger in Prescott/Kydland's work, it's that some will use it to justify any existing policy -- no matter how bad. But that's not what they're saying.

Their points are simply that policy-makers must balance negative effects now with good later, or vice versa, and that good policies can be useless without government commitment. You knew that. But Congress didn't.

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