Revolution in economic theory positive step

Freedom Newspapers

It’s more than a little gratifying when the most recent winner of the Nobel Prize in economics tells CNBC, the cable financial channel, that President Bush’s tax-rate cuts were “pretty small” and really should have been bigger.

Said Edward Prescott of Arizona State University: “Tax rates were not cut enough,” because lower tax rates provide increased incentives for people to work harder and lead to future economic growth.

The Nobel committee did not award the prize to Prescott — jointly with longtime colleague Finn Kydland, a Norwegian-born scholar who has just moved to University of California-Santa Barbara from Carnegie-Mellon University in Pittsburgh — for having that indubitably healthy opinion. But it grows from a lifetime of highly respected and influential work.

Prescott and Kydland have revolutionized certain aspects of the study of macroeconomics, which is the study of the economy as a whole as compared with analyzing transactions and decisions at the level of the individual person or company. They looked at business cycles in a more sophisticated way, doing rigorous research into the ultimate origins of wealth, in a quest to explain why some countries are richer while others are poorer.

An inquiry into “time inconsistency,” a 1977 paper cited by the Nobel committee as an important contribution, might seem arcane, and it is. But in a nutshell, the paper noted that while high inflation is bad — zero inflation would be “time consistent” — governments are tempted to increase inflation in the short run, then people anticipate it, which fuels more inflation in a vicious cycle. Remember the “stagflation” of the 1970s?

Is there a solution? Short of abolishing the Fed, appoint a central banker who really hates inflation and doesn’t care what anybody else thinks, least of all others in government. Alan Greenspan’s appointment to the Fed in 1987 was popular in part because Prescott and Kydland’s ideas had been widely accepted by then. Greenspan built on Paul Volcker’s work as Fed chair.

The two economists continued to explore how stagflation, which defied standard Keynesian theory calling for the Fed to manipulate monetary policy to smooth out the cycles, could have happened. In the 1980s they published research that demonstrated that “real changes” — technological innovations, oil-price shocks — account for 70 percent of the fluctuations in economic growth and federal monetary policy controls little. So it’s best to be consistent and steady in monetary policy rather than trying to get too creative and manipulative.

More recently came a paper on why Americans work more than Europeans these days — which wasn’t true in the 1970s. The main reason? Higher European tax rates, which kill the incentive to work harder and longer. Another reason is stifling innovation and competition by awarding monopolies to politically influential cronies.

Prescott said he wants to do more to explain the reasons decentralized market mechanisms improve human welfare, explaining the reasons in precise and accurate language. “We’re at a point where sound analytical methods, widely accepted, will give reliable answers to policy questions regardless of personal bias,” he said. “That’s exciting.”

Prescott and Kydland have explored relevant problems, and evolved from mavericks to conventional wisdom to influential in shaping policy. That influence has been beneficial and deserves to grow.