Nobel Winners Without Much Impact
In academic circles, it's considered bad form to ask a macroeconomist to predict how fast the economy will grow next year. That's grubby work, best left to seat-of-the-pants practitioners. Then again, shouldn't economic theories from the ivory tower be judged by the accuracy of the real-world predictions they generate?
Apparently not, at least if you're sitting on the committee that awards the Nobel prize in economics. On Oct. 11, the award went to Edward C. Prescott, 63, of Arizona State University and the Federal Reserve Bank of Minneapolis, and Finn E. Kydland, 60, of the University of California at Santa Barbara and Carnegie-Mellon University. They won for two key papers: The first demonstrated that monetary policy works best when central bankers pursue consistent policies; the second tied the ups and downs of the business cycle to technological progress.
But while economists generally laud Prescott and Kydland for the insight and originality of their work, its practical impact has been limited. That speaks volumes about the parlous state of macroeconomics today. Ken Matheny, a senior economist at leading forecaster Macroeconomic Advisers LLC in St. Louis, says that while he admires the Nobelists, "In a sense, their work has had very little impact on what we do."
Of the two papers, the first, a 1977 study of the problem of "time inconsistency," seems to have had the most influence. It said that policymakers lose credibility, and thus leverage over the economy, when policies are inconsistent over time. The Federal Reserve in the 1970s said it was committed to curbing inflation, for example, but it periodically lowered rates to ease joblessness, which stoked inflation. Eventually, people stopped trusting the Fed to keep prices in check, one factor that led to years of stagnant growth and high inflation.
Central bankers appear to have learned that lesson since. The 1977 paper made clear that they should not goose growth with low interest rates if doing so would call into question their commitment to sound money. Some central banks, including those of Britain and New Zealand, have announced target rates for inflation; others, like the Fed, have earned the markets' trust without setting explicit targets.
Fiscal policymakers, though, haven't absorbed the lesson and probably never will. Lawmakers seem unable to commit themselves and their successors to restraints on spending -- witness the failure of budget caps to control deficits.
More controversial, though, has been an idea that Prescott and the Norwegian-born Kydland came up with in 1982 that was later dubbed "real business cycle" theory. It was an alternative to Keynesian economics, which had difficulty explaining the sluggishness of the '70s and early '80s. As later developed by other economists, the theory held that the ups and downs of the business cycle were affected mainly by fluctuations in the rate of technological progress and other supply shocks such as oil-price spikes, and much less by monetary policy or shifts in consumer demand.
While appealing in its novelty, the theory doesn't quite match reality. It predicts that a jump in the rate of technological progress would cause jumps in both output and number of hours worked. That was true in the '90s, but no longer. Now high productivity growth seems to be suppressing job growth. It's also hard to build a real-business-cycle model that produces usable forecasts. At forecaster Global Insight Inc. in Waltham, Mass., Chief Economist Nariman Behravesh says "the data's just not there" to create a workable real-business-cycle model.
This is the first Nobel for macroeconomists after four straight years of awards to microeconomists and statistical experts. Other economists are split over whether it was a good choice, one symptom of the lack of direction in the field. "It's not clear that we understand that much more about macroeconomics than we did 30 years ago," says Paul Ormerod, a British economist and author of The Death of Economics. In an Oct. 12 press conference, Prescott said: "Economics has matured. It's become a hard science." If only that were true.
By Peter Coy in New York