Economics - General

Nobels for Kydland and Prescott

John Quiggin12 Comments

The winners of The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel for 2004 are Finn Kydland and Edward C. Prescott for their work on time-consistency in policy and on real-business cycle models. In my view, the time-consistency work is important and has generally been a positive influence on policy makers1].

Real business cycles models were an exciting idea in the 1980s, and continue to influence the way people think about macroeconomics, but haven’t in my view, lived up to their early promise.

One discovery of Prescott’s that I think is very important, but isn’t part of the Nobel citation is the equity premium puzzle, which he discovered jointly with Rajnish Mehra. This is the fact that thegap between the rate of return on equity and the rate of interest on bonds is much greater than can be accounted for by standard arguments about risk. This in turn explains why governments generally lose money from privatisation, as Simon Grant and I have pointed out.

fn1. Some central banks, like the RBNZ under Don Brash took ideas like credible commitment to an extreme, with bad results. But then, in this period, policy makers in NZ took everything to extremes and usually got bad results.

12 thoughts on “Nobels for Kydland and Prescott”

  1. John, where did your fam first post go? One moment I’m writing a comment, next thing this thing appears in its place. I’m really frustrated by the lack of blog discussion about the interesting left-of-centre policies these guys, who I and most other lefties assumed were right wing crackpots, are bringing out. Could you post on this paradox?

  4. Phew, from your headline in my news feed I instantly leapt to the conclusion that the gong went to socialist UK Deputy PM John “2 jags” Prescott.

  5. John Q. – can you recommend a good book or paper on the problems of the New Zealand Economy over the past 40 years? I’ve heard about bits about it and I would like to read more. TIA

  7. Pr Q might like to mention one other important aspect of Prescotts work, which will get alot of airing in the right wing media, is his scientific support for supply side economic theory when comparing the effect of marginal tax rates on USA with USE labour supply:

    Americans now work 50 percent more than do the Germans, French, and Italians. This was not the case in the early 1970s when the Western Europeans worked more than Americans….
    The labor and consumption tax rates can be combined into a single tax rate [T], which I call the effective marginal tax rate on labor income. It is the fraction of additional labor income that is taken in the form of taxes holding investment, or equivalently savings, fixed…
    If France were to reduce its effective tax rate on labor income from 60 percent to the U.S. 40 percent rate, the welfare of the French people would increase by 19 percent in terms of lifetime consumption equivalents. This is a large number for a welfare gain.
    This estimate of the welfare gain takes into consideration the reduction in leisure associated with the change in the tax system and the cost of accumulating capital associated with the higher balanced growth path.
    The reduction in leisure is from 81.2 hours a week to 75.8 hours, which is a 6.6 percent decline in leisure. I was surprised to find that this large tax rate decrease did not lower tax revenues.

    Clearly, supply side incentives had diminishing returns after Reagans Big Bang income tax cut. So the USA has enough incentive to get on with the job in the nineties. But USE workers could use a bit more carrot. They need a Reagan.

  8. JQ, could you elaborate please as to the ‘early promise’ of real business cycle ideas. The whole thing seems barmy to me, but I’d be interested in why you think the ideas had promise.

  9. The reference to “early promise” was more a statement of how the economics profession in general viewed RBC models in the early 80s than what I thought about them.

    For me, the idea that seemed to promise great things but didn’t deliver was the Barro-Grossman disequilibrium approach.

  10. The destructive part of RBC theory was useful: it forced people to accept that evidence for deterministic cycles – as proposed by Kuznets, Kalecki and so on – cannot easily be found in macroeconomic time series. But the constructive part, according to which fluctuations can all be explained by stochastic changes in tastes, resources and technology, was – let’s see if I can think of a fair and objective way of characterising it – barmy.

  11. I was interested to see you spell Finn’s name as Kydlund. Is that the Norwegian spelling? I’ve only ever seen it spelled as Finn E. Kydland!

    I agree that Prescott has made other important contributions and it is useful to point that out.

    As usual though I hear the standard complaints about RBC models – negative technology / productivity shocks can’t be that important and labour elasticities don’t match (plus unemployment isn’t exactly involuntary in most of these models).

    However, I think that people who say the RBC school was barmy completely miss the point about innovative academic research – sometimes it has to start with overly simplistic, yet novel ideas which aren’t quite right in their formative stages but which spawn further research effort in the right direction. The research by these two prize winners was a major step towards ensuring that modern dynamic macroeconomics is based on principles of internal and external consistency and that modern macro, including the diminating new Keynesian school of Stiglitz, Mankiw, Yellen et al, moved away from the inconsistencies, ad hocery and weird axioms of old style Keynesianism and Monetarism.

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