Back in the 1950s and 1960s, the economy generally percolated along without major bumps and bruises. This long period of relative calm, coupled with the post-war conversion to the theories attributed to John Maynard Keynes, led many to believe that business cycles could be managed and were pretty much a thing of the past.
When I took my first economics classes in the early 1970s, textbooks, articles, and even senior government officials spoke of “setting the dials,” and “fine tuning” policy to achieve desired outcomes. It was as if you could turn a few knobs and change the growth rate from 3.5% to 3.7% or 3.8%. (As an aside, Keynes never said anything like that. His zealous disciples did, but he was far too smart for that.)
Then, along came the energy crisis, and for the past three decades, things have been a bit more chaotic. We have seen Nixon’s wage and price controls, the misery index, several oil shocks, corporate scandals, terrorists’ attacks, and a war. No one would remotely suggest in these turbulent times that we can set the dials and make the economy whatever we want it to be. Not even close.
As this unsettling situation unfolded in the early 1970s, my chosen discipline was searching desperately for new ways to look at the world. Among those who stepped into the breach were Norwegian Finn Kydland and American Edward Prescott, two Carnegie Mellon graduates who collaborated to alter our understanding of business fluctuations and the policymaking process. In recognition of their seminal efforts during the late 1970s and early 1980s, they were awarded the 2004 Nobel Memorial Prize in Economics. Since their names are not exactly household words beyond the rarified air of a thin slice of academia, it is worthwhile to pause and briefly explore how they changed our understanding of the complex modern world. (As another brief aside, most of you are no doubt aware that I was recently honored and humbled to be nominated by the International Institute for Advanced Studies for “the Prize” in the year 2005 and beyond—until I win or die! As a practical matter, there is no reason to even be moderately curious about my chances until 2015 or so. Nonetheless, I have received literally thousands of good wishes and kind words from around the world, and thought this might be an appropriate juncture to say how truly grateful I am to all of you.)
In a seminal paper in 1977, Kydland and Prescott pointed out a “time consistency” dilemma in economic policy. The basic idea is that the best long-term ideas can be foiled by short-term considerations (such as politics). For example, suppose the Federal Reserve (Fed) decided that it should keep inflation low once and for all, announced it to the universe, and was believed by all individuals and firms. In anticipation of the outcome, wages would be lower than otherwise (as no one would see the need to hedge against inflation), and interest rates would be high, as the Fed would need to keep the supply of money tight to hold prices down (long-term inflation is caused by “too much money chasing too few goods”). This pattern would, in turn, lead to less investment and, hence, hiring than would occur otherwise. Then, reality sets in. A sluggish job market (possibly accompanied by an impending election) can cause pressure to “loosen up.” The end result may well be that policy is eased, inflation ramps up, and expectations are not realized. Thus, by failing to stick with long-term plans, the good intentions of policymakers can make things worse than ever (remember the days of stagflation?).
A few years later, Kydland and Prescott teamed up again to point out a similar timing problem in short-term and long-term economic analysis that helps us to understand the business cycle. The issue is not unlike that confronting theoretical physics. We have very convincing and rigorous explanations of how the universe works, and equally compelling notions of how miniscule sub-atomic structures behave. The only problem is that the two sets of concepts are fundamentally inconsistent with one another, and ultimately that great big universe is made up of those tiny little gizmos. Traditional economics had a similar dilemma. We explained short-term fluctuations via “demand shocks” such as oil embargoes, wars, or the like. On the other hand, we explained long-term performance through supply side phenomena, such as workforce availability and capital investment. Kydland and Prescott demonstrated that in reality, the two depend on each other, as short-term decisions ultimately are linked to long-term outcomes. As a simple illustration, lower marginal tax rates in the US (a short-term policy decision) are the primary reason that American workers are decidedly more productive than their European counterparts.
These notions may seem obvious, and, in all fairness, I have tried to simplify them from their opaque mathematical derivations. To truly appreciate their significance, you have to consider the context in which they were offered. Economists had just figured out they didn’t have all the answers and were scrambling to again define their relevance (it is no accident that the Nobel Memorial Prize in Economics was initiated in 1968, at the height of the seeming scientific precision). Kydland and Prescott were among the group that essentially said, “If we can’t do everything, let’s at least do something to better understand and contribute to a rapidly changing world.” In so doing, they were both important architects of modern policy and significant forerunners of much of what followed.