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Source link: http://archive.mises.org/2587/economics-nobel-2004/

Economics Nobel 2004

October 11, 2004 by

Finn Kydland (Carnegie Mellon) and Edward Prescott (Arizona State) have been awarded the Nobel Prize, according to the Swedish Academy of Sciences, for their work on time-consistent policy and the generation of the business cycle. While Austrians have cited their work in criticism of countercyclical policy, Austrians have criticized “real business cycle theory” as not providing a full account of cause of fluctuations. See John P. Cochran: “Capital Based Macroeconomics: Recent Developments and Extensions of Austrian Business Cycle Theory“; and Roger Garrison: “The Austrian Theory of the Business Cycle in the Light of Modern Macreconomics.” Kaza shows that while Prescott and Kydland have largely ignored the Austrian contribution, apart from citing Haberler, other New Classicals have criticized the Austrians; Garrison responds in defense of the Austrian theory. Fritz Machlup (1976) (cited in Garrison) sums up the difference in outlook: “Monetary factors cause the cycle but real phenomena constitute it.” Go here for a full look at Austrian theory.

{ 4 comments }

Roger Garrison October 11, 2004 at 8:56 am

The key innovation attributable to Kydland and Prescott (“time to build”) appeared some 22 years ago. Fifteen years ago, I suggested that “this development could lead to reintroduction of capital theory into macroeconomics” (see excerpt below). Instead, the seeming empirical irregularity that could be resolved only by time-to-build considerations became the basis for discrediting this strand of new-classical theorizing.

In an article forthcoming in the Review of Austrian Economics, Michael Montgomery offers empirical support for the Kydland and Prescott hypothesis. Montgomery uses the more Austrian-oriented term “intertemporal capital complementarity” to capture the same idea.

Excerpt from Roger W. Garrison, “The Austrian Theory of the Business Cycle in the Light of Modern Macroeconomics(Link),” Review of Austrian Economics, vol. 3, 1989, pp. 3-29:

One encouraging development within the New Classical school, however, deserves mention. The assumption of rational expectations, coupled with assumptions of costless information and instantaneous market clearing, implies that a monetary disturbance should not have any systematic real effects beyond the period in which the disturbance occurs. Empirical studies, though, reveal a certain persistence of effects. Some New Classicists [Kydland and Prescott, 1982] attempt to account for this persistence by incorporating “time-to-build” considerations into an otherwise capital-free construction. That is, money-induced decisions to initiate a multi-period production process affect in systematic ways the decisions to be made in subsequent periods. While time-to-build was added belatedly and only to resolve a disparity between theory and evidence, this development could lead to reintroduction of capital theory into macroeconomics.

Kydland, Finn E. and Prescott, Edward C. “Time to Build and Aggregate Fluctuations,” Econometrica, vol. 50 no. 6, (November) 1982, pp. 1345-70.

Michael Davlin October 12, 2004 at 10:14 am

As a layman who’s read several newspaper descriptions of Kydland’s and Prescott’s achievement, I’m having a hard time identifying exactly where their Nobel level originality lies. For example, this morning the New York Times printed this:

Their first paper, which appeared when both were at Carnegie Mellon University in Pittsburgh, argued in effect that government officials should adhere to rules rather than resort to short-term policy shifts when circumstances change. If holding down inflation is the Federal Reserve’s goal, for example, then the Fed should refrain from sharp cuts in interest rates during hard times, an approach that might result in too much stimulus and too much inflation later on. Better to resist changes in policy and suffer through some hardship if minimizing inflation makes people better off in the long run, their thesis maintained.

And this:

The two economists developed their second paper in the summer of 1980. Mr. Kydland had returned temporarily to his undergraduate alma mater, the Norwegian School of Economics and Business Administration in Bergen, and Mr. Prescott had gone there as a visiting professor with his wife and three children. Out of that collaboration came the view that supply shocks or new technology produce booms and busts, not changes in demand.

There was one catch in their work that has riled a faction of the economics profession. The Prescott-Kydland finding assumed that demand was always at a high level. Everyone who wanted to work did so at the prevailing wage and all production could be sold at the existing market price. Supply, in effect, created its own demand. Thus, they posited, changes to the economy came not from fluctuations in demand, but from shocks.

The oil embargo that caused sharply higher prices and the 9/11 terrorism would be negative shocks, while the Internet and high-speed computers would have a positive impact, increasing productivity and growth. The negative supply shocks, and not policy, cut into consumer spending and job creation.

“Everyone thought that monetary policy shocks – sharp changes in interest rates – made economic growth fluctuate,” Mr. Prescott said in a telephone interview yesterday. “We found, to our surprise, that persistent changes in real factors gave rise to fluctuations in the business cycle.”

That thesis in the second paper was controversial because it went directly against the worldview of John Maynard Keynes, the famed British economist who held that the Depression was a result of weaker employment and weaker demand for the goods and services than the nation was capable of producing.

And, finally, this:

The first paper cited in the Nobel award, titled “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” is considered by many economists to be a valid and innovative framework for considering public policy over a wide range – not only Fed interest rate policy but policies on such matters as building homes on flood plains.

If houses go up in such high-risk areas and a flood destroys them, policy makers are faced with the question of whether to provide aid to help the victims rebuild or to let them bear the financial burden of rebuilding. Prescott-Kydland would say it is best not to provide aid, because in the long run it is better if homes are not constructed on flood plains where there is a risk of their being destroyed. While the government typically extends aid, of course, the Prescott-Kydland perspective is a useful tool for examining such policy issues, says Alan Blinder, a Princeton University economist.

“One of the hallmarks of a great intellectual achievement is that it brings into a common framework a wide variety of seemingly different problems,” Mr. Blinder said.

Somehow, the ideas in the first two NYT excerpts sound awfully familiar (especially on this web site), and seem to imply that they completely dismiss monetary disturbances. I would be intrigued if they argued that monetary policy can produce real disturbances that lead to booms and busts, and that real disturbances can occur in the absence of monetary disturbances. That seems plausible as a result of plan inconsistencies, technology innovations, herd effects, or even due to more subtle (chaos theoretic) instabilities in an unfettered market. Demonstrating any of those possible effects would be noteworthy, but doing so wouldn’t seem to justify tossing monetary effects out the window.

The conclusion in the third NTY excerpt, that it’s not so great an idea to build or subsidize reconstruction of houses in flood plains, is not only a commonly expressed conclusion, but one scarcely needs an economics degree, let alone a Nobel Prize, to reach it.

So, where’s the beef in this Nobel award? Is it just that they’ve re-expressed these familiar ideas in a dynamic general equilibrium model driven by stochastic diffusions? Sometimes, a joke only works if it’s delivered properly; is the same true of economic theories?

olmedo October 12, 2004 at 3:31 pm

Tautologies, tautologies, tautologies……..

That is the real language of mainstream economics.

The whole business about being “tautological” is that, if you are “tautological” enough, you will put doubt even in the most self evident of things.

This is something that politicians, their bosses, love because it gives them the freedom they need to do their things.

The pity is that we Austrians have give too much attention to these charlatans legitimizing their input.

Olmedo

rtr October 13, 2004 at 4:37 pm

Doesn’t the Swedish Royal Academy have to give out a Nobel Prize every year? Of course, what are the economic implications of inflating the number of existing Nobel Prizes and equating them generally? Perhaps they’ve lost some luster and are becoming more like popularized “lifetime achievement awards” that are granted because the granters want to feel good about including the recipient and the recipient is not up for the “work of the year” award and it would be awkward to perpuate a monopoly by having the same individuals repeatedly win the “work of the century” or “work of the generation” award? Perhaps some members of the Nobel Union can answer these questions. I’d also like to see a comparative study of the income of Nobel Union members vs. non-union members of the same profession. ^_^

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