Economics Nobelists. Finn Kydland (left) and Edward Prescott share this year's prize for work on why economic policy doesn't always work out as planned.

Economies Behaving Badly

It's no great insight that governments behave in a less than optimal manner. Understanding why is another story. This year's Bank of Sweden Prize, otherwise known as the Economics Nobel, goes to Finn Kydland and Edward Prescott, two economists who figured out why good governments do bad things to good people. "It's a great event," says Robert Lucas, an economist at the University of Chicago who won the prize in 1995. "These are great economists."

In the mid-1930s, economist John Maynard Keynes came up with a very successful framework for analyzing broad trends in the economy--such things as unemployment, consumption, production, and inflation. The Keynesian picture seemed to promise a utopia; a rational government could keep inflation and unemployment in check through an optimal strategy of setting taxes and interest rates and other tools of economic policy.

But as with all utopias, an optimal, ideal economic policy turned out to be a pipe dream. Inflation and unemployment often fluctuated out of control, and occasionally a government's well-intentioned policy would make matters worse. Sometimes, seemingly impossible and horrible things would happen to an economy, even when under control of a rational and benevolent government. For example, in the late 1970s, inflation and unemployment in the United States rose dramatically at the same time--something that is forbidden in the Keynesian picture.

In the late 1970s and early 1980s, Prescott, of Arizona State University in Tempe, and Kydland, of Carnegie Mellon University in Pittsburgh and the University of California, Santa Barbara, collaborated to figure out why fiscal policy often fails to have the desired effects. The two showed that governments have a problem committing to a policy; this lack of commitment harms their credibility, which, in turn, can lead to an undesirable outcome. For example, a tax cut might not have the effect that planners predict because citizens don't trust that the cuts will persist. "The effect of a tax cut today depends on whether people think it is permanent or just temporary," says Lucas. That kind of insight "was a huge break from what all of us were doing at the time." The change of thinking that ensued also led to a better understanding of the causes of business cycles that rattle through an otherwise stable economy.

Related Sites
More information about the 2004 Economics Nobel
Prescott's site at Arizona State
Kydland's site at Carnegie Mellon

Posted in Economics