Analysis: Nobels for rules not discretion

By IAN CAMPBELL   |   Oct. 11, 2004 at 3:03 PM
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It is an earnest body but you begin to wonder if the Swedish Academy of Sciences, which selects the Nobel prize-winners, has a sense of irony.

Monday the academy awarded the Nobel prize in economics to an American, Edward C. Prescott, and Norwegian, Finn E. Kydland. The "rules rather than discretion" influence of Prescott and Kydland's work has been far-reaching. The low inflation of the past decade is almost certainly one of its consequences. Yet discretion seems in recent years to have again become paramount in the fiscal and monetary policy of the world's largest economy, the United States, as U.S. President George W. Bush and Federal Reserve Chairman Alan Greenspan have swung fiscal and monetary policy towards the extremely stimulatory. Which rules are they obeying?

A rules-based approach to economic policy-making was one of the two areas of research for which the Swedish Academy of Sciences has applauded and rewarded the work of Prescott and Kydland. According to the Academy, the Keynesian demand-side approach to economics named after the British economist John Maynard Keynes appeared successful in interpreting macroeconomic performance until the mid-1970s. But then the supply-side shock of the oil price rise effected by the Organization of Petroleum Exporting Countries forced up both inflation and unemployment, generating the so-called stagflation of the 1970s. According to the Academy, policy makers "appeared to make matters accommodating private sector expectations of high price and wage increases."

Prescott and Kydland addressed this policy problem. In "Rules rather than discretion: the inconsistency of optimal plans," published in 1977, they argued that if governments do not commit to a binding restraint they will face a credibility problem. In layman's words, people will expect government policy to change and will base their behavior on the changes they foresee. Rational expectations come into play. Government plays a game with the private sector. Prescott and Kydland's research argued that this game generated a less good outcome than consistent, rules-based policy-making.

These insights have led to much further research on rules-based policy-making by other academics and to concrete changes in fiscal and monetary policy-making. They are by themselves a major contribution to the science of economics. But "time consistency" is not the only research for which the Nobel committee cited the work of Prescott and Kydland. They were also praised for their work on the role of new technologies in the business cycle.

According to the Swedish Academy, "Kydland and Prescott demonstrated that shocks on the supply side may have far-reaching effects. In their business-cycle model, realistic fluctuations in the rate of technological development brought about a covariation between GDP, consumption, investments and hours worked close to that observed in actual data."

According to Professor Patrick Minford of the University of Cardiff Business School, Kydland and Prescott's "Real Business Cycle model explains the big swings in cycles via productivity surges and declines. This is a highly persuasive idea which also does well empirically and is a corrective to all the emphasis on demand shocks since Keynes."

Prescott and Kydland have influenced modern-day policy-making considerably.

"We are all Keynesians now," once famously said another Nobel prize-winning economist, the monetarist, Milton Friedman, though he meant the remark to indicate that all economists use Keynesian language and apparatus, not that they shared his conclusions.

Perhaps now we could state that all policy-makers are "Kydland and Prescott rules-based."

Central banks have tended to become independent of governments in recent decades, more technical, and oriented towards establishing their long-term credibility via consistent policy-making. One result of this has been the much lower inflation of the past decade.

But the rules to be employed and the level of fidelity remain uncertain. And so, for good or ill, discretion continues to come into play. This can be seen to have occurred in the past few years.

The European Central Bank, for example, has been much criticized for its adherence to strict inflation and money growth targets; so much so that it has weakened in the past year the importance it attaches to monetary growth as a guide to policy.

Meanwhile, according to John Butler, UK economist of HSBC bank in London, the then newly independent UK central bank, the Bank of England, established its policy credibility from mid-1997 to mid-2002 by hitting its inflation target of 2.5 percent. But Butler says that the focus shifted subsequently "from ensuring medium term stability towards supporting short-term growth at all costs. Mopping up the fall out from the equity market crash became paramount, even at the consequence of creating a housing market bubble."

In the United States, Federal Reserve Chairman Alan Greenspan, who has placed great emphasis on technology advances and productivity growth as justification for a relatively loose monetary policy, obeys no explicit policy rule though, in Minford's view, he does have an implicit inflation target in mind. But, as in the UK, Greenspan swung the policy lever abruptly to very low interest rates in 2001 and 2002 as he sought to cope with the deflationary effects of the bursting of the late 1990s equity price bubble. Now it is U.S. house prices that are bubbling.

So the question remains, which rule or rules? And how faithful should one be to the rules?

Investigations into these topics can be seen as sequels to Kydland and Prescott's original breakthroughs. Perhaps above all the new wild card that must be factored into policy research in the monetary area is the role of asset prices. Rising and falling stock markets have proven in recent years the equivalent of the oil price shocks of the 1970s, alarming policy-makers and leaving them uncertain. House prices may hold new surprises. These are among economists' next challenges.

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