Jewish World Review Dec. 15, 2004 / 3 Teves, 5765

Robert Robb

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Consumer Reports


Finally a maverick Nobel Prize winner for economics?


http://www.jewishworldreview.com | A big fuss has been made locally, and rightfully so, over the Nobel Prize for economics going to an ASU professor, Edward C. Prescott. But little attention has been paid to the insights for which Prescott has been honored.


Prescott's lecture upon receiving the award last week offers an opportunity to partially remedy that.


I say partially because when economists gather, particularly when they are putting on the dog, they tend to talk mathematics, not English.


As best I can figure it out, Prescott was honored for advancing two important understandings about political economy.


The first raises questions about the extent to which government should be in the business of attempting to fine-tune the economy.


Prior to Prescott, the economic consensus was that government should use monetary and fiscal policy to modulate growth rates and business cycles, alternately stepping on the gas or putting on the brakes as circumstances warranted.


Many had pointed out that the governmental tools available were rather blunt for the task, and that it was difficult to time the intervention right — by the time government got around to stepping on the gas or putting on the brakes, the economy had often already moved on. The unique insight of Prescott and his collaborator Finn Kydland was that, even if done right, attempts to fine-tune the economy could be self-defeating.


That's because the prescribed fix necessarily changes over time. In his lecture, Prescott referred to "the inconsistency of optimal plans."


Inconsistency in monetary and fiscal policy, however, introduces uncertainty for those in the private sector who have to take the actions that actually bring about the results sought.


Uncertainty creates inefficiency and attempts to respond not only to what policy currently is, but what it might be when it changes.


The result may very well be a worse economy than if the government hadn't attempt to modulate it.


The better approach would be for government to establish monetary and fiscal policies conducive to productive economic behavior and stick to them. As Prescott put it in his lecture: "Rules rather than discretion."


The second insight has to do with the nature of business cycles themselves. The conventional wisdom had been that business cycles were driven in large part by consumer demand. Prescott and Kydland, however, demonstrated that supply side changes had as much, if not more, influence on them.


In his lecture, Prescott showed a chart illustrating that, since 1960, consumer consumption has held pretty steady while business investment has fluctuated greatly.

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There's some inherent common sense to this. Household income does fluctuate as business cycles ebb and flow, but, except for rare severe contractions, not wildly. And consumers have ways of mitigating the effect of income fluctuations through savings and debt.


Businesses, however, seek not merely to serve current consumer preferences, but to change them. So, investment fluctuates more widely as opportunities are perceived and previous bets either pay off or fail.


One of the insights Prescott has stressed recently is the extent to which economic performance is tied to the willingness to provide labor and the effect of taxes on that willingness.


In his lecture, Prescott demonstrated how closely changes in U.S. Gross Domestic Product are tied to changes in aggregate hours worked. And he has argued that the difference in hours worked between Europeans and Americans is mostly attributable to differences in the after-tax return for such work, rather than a greater preference by Europeans for leisure.


While the economic world has embraced Prescott's insights, the public discussion of political economy lags considerably behind.


The last recession was pretty clearly a classic business cycle churn, as business overinvested toward the end of the 1990s, retrenched, and then re-engaged. And a relatively mild one at that.


Yet the focus of the public discussion was on governmental policies and the need to goose consumer spending, which in fact had remained rather healthy. The budget rules of Congress — under which 60 votes are required in the Senate for permanent changes — have led to inconsistent fiscal policy by design, as various tax cuts fade in and out.


Undoubtedly inconsistent good policy is preferable to consistent bad policy, which is the practical choice the political alignment in Congress and current budget rules allow. But perhaps Prescott could next study how to accelerate the time lag between the discovery of economic sense and its application by policymakers.



JWR contributor Robert Robb is a columnist for The Arizona Republic. Comment by clicking here.

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