During the first fortnight in October, economists all over the world speculate on who are likely to win the Nobel prize. Several names are tossed around ' the giants in the profession have already received the prize, and so there no obvious candidates who tower over everyone else. In fact, the Nobel committee's choices have sometimes taken many people by surprise because the winner(s) were not perceived to be leading contenders. This cannot be said of the committee's choices for this year ' Finn Kydland and Edward Prescott ' because the two have together had a profound influence on modern research on dynamic macroeconomics through their own work on the time consistency of economic policy and real business cycles.
It is easy to underestimate the significance of the problems posed by time consistency for policy-making in a decentralized economy. Time inconsistency is said to arise if a policy-maker announces some policy to be carried out in the future, but then reverses the nature of the policy before the announced policy is implemented, even though nothing in the environment seems to have changed. A first reaction to this definition may be 'So what' Don't politicians always make tall promises in order to garner electoral support, only to renege on their promises after winning the election' How can anyone be awarded a Nobel prize for pointing out that politicians are not to be trusted'
If time inconsistency simply meant reneging on a promise, the phenomenon would certainly not be at all interesting. But time consistency has become a crucial part of every economist's vocabulary because this can occur even when the policy-maker is a benevolent social planner, genuinely interested in implementing those policies which are beneficial to the community affected by such policies. Actually, related phenomena have occupied the attention of economists for several decades. For instance, several economists have pointed out that 'dynamic inconsistencies' can occur for a variety of reasons, most notably if tastes change. For instance, every smoker will typically resist any ban against smoking in public places, but then support such a ban if he gives up smoking! But Kydland and Prescott were pointing out a subtler phenomenon, and one posing serious challenges for effective policy-making.
Suppose, for instance, that the government wants to raise the level of capital accumulation in the economy. An 'obvious' solution is to promise low future taxes on capital. This promise will induce private savings in the economy because individuals will look forward to high net returns on their savings. So, if the promise of low future taxes is believed, then the economy may well achieve the desired level of capital accumulation at some point in the future.
But what should the government do once the economy has achieved its target level of capital' It has to raise a certain level of tax revenue in order to finance its expenditure. Taxes on labour incomes are distortionary because they reduce incentives to work. On the other hand, if capital accumulation has already taken place, a tax on capital will typically be less distortionary because the flight of capital is unlikely. So, the government may well raise taxes on capital because this is the optimal policy after the desired level of capital accumulation has occurred.
In other words, the optimal response of the benevolent government, interested in maximizing social welfare, is to renege on its earlier promise of low taxes on capital. But notice that sophisticated individuals should be able to anticipate that this will indeed be the path followed by the government if they raise their level of savings. Hence, their optimal response to the government's promise of low future taxes on capital is to ignore such promises! This would compound the government's difficulties in achieving its desired level of capital accumulation unless the government can somehow convince the public that it will not follow time-inconsistent policies. Often, the government can credibly commit to follow time-consistent policies only if there are appropriate institutional devices. For instance, the existence of an autonomous central bank, which acts as a watchdog over the government's macroeconomic policies, can sometimes allow for such credible commitment.
Kydland and Prescott have also been instrumental in transforming ideas about the factors underlying fluctuations in aggregate output. Until roughly the Seventies, Keynesian ideas dominated research on macroeconomic phenomena such as business cycles. The focus was almost solely on aggregate demand. The traditional view was that excessive demand leads to an overheated economy, inflation and high outputs, while shortfalls in demand caused unemployment and a downturn in economic activities. This view also resulted in relatively simple stabilization policies ' stimulate aggregate demand by appropriate expansionary monetary and fiscal policies in times of high unemployment, and curb demand in times of high inflation. It was almost as if the only choice which had to be made by policy-makers was to determine the most desirable combination of unemployment and inflation.
Some sceptical economists questioned this somewhat simple-minded belief, at least partly because there was no consistent microeconomic theory to backup the Keynesian theories and prescriptions. But their views did not receive much attention mainly because Keynesianism seemed to work. Indeed, there were hardly any major fluctuations in economic activity in the post-war period prior to the Seventies, and this was hailed as evidence that Keynesian stabilization policies were effective.
The oil shock of the Seventies changed all that ' stagflation was on every economist's lips as the world witnessed a new phenomenon ' rising prices along with high unemployment. The economic turbulence of the Seventies demonstrated the problems with conventional Keynesian thought. It was increasingly apparent that much greater attention had to be paid to the microeconomic foundations of macroeconomics ' after all, the overall economic activities was the sum total of the activities of individual households and firms. Incidentally, two other Nobel laureates ' Milton Friedman and Robert Lucas ' have also been leading critics of na've Keynesianism.
Kydland and Prescott's paper in 1982 laid the microeconomic foundations of business-cycle analysis. In particular, they emphasized that the correct formulation of business cycle analysis must specify how individual agents whose objective is to further their self-interest, react to changes in the economic environment, and how these responses shape the time-path of aggregate economic variables such as national income, employment and the overall rate of inflation. Their analysis debunked the thesis that business cycles were essentially caused by variations in aggregate demand around along-run trend rate of growth. Perhaps inspired by the empirical consequences of the oil shocks of the Seventies (which affected the supply side of the economies), Kydland and Prescott showed that supply side shocks may also have far-reaching effects.
The new school of thought on business cycles initiated by Kydland and Prescott is still in its infancy, and definitive theories are yet to be established. But they have established that at least some of the fluctuations associated with business cycles are not aberrations from along-term 'equilibrium path', and so stabilization policies cannot simply be designed to bring back the economy to the equilibrium path. Correct policies must instead change the equilibrium path itself. Of course, this is a much harder task. But, at the very least, Kydland's and Prescott's research has focussed attention on the right set of questions to be asked.