Monday, October 11, 2004

In Praise of Finn Kydland and Edward Prescott

The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2004 was awarded to Finn Kydland and Edward Prescott "for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles." Congratulations to both of them on the well deserved recognition.

The two parts of their work are significant to the way economics is taught and new research developments are made. I have never done academic work on business cycles, but their insights on time consistency are directly relevant to public finance where I have done research. Marginal Revolution has a brief discussion of this aspect of their work, linking it to a discussion of why it is difficult to maintain an equilibrium in a market like prescription drugs that I addressed a few days ago.

The logic (like much in economics) is obvious once you see it. Think about a project that requires a firm to make an investment in order to generate profits in some future period. A government has every reason to claim that it will not tax those future profits, so that the firm will undertake the project. However, once the capital is in place and production is underway, the government can now tax the firm's profits heavily, since the firm has little choice now but to use the capital in production, despite the high taxes.

If the government has a reputation for behaving opportunistically, then firms will not undertake the investment. This insight applies equally well to monetary policy. A central bank that allows inflation to rise opportunistically (to lower real wages and thereby boost employment in the short term) will not be able to convince firms and workers to sign long-term contracts that require price stability. In the long term, economic activity will be lower as banks will be less willing to lend, firms will be less willing to invest, and workers will be less willing to work.

Kydland and Prescott's work shows why policy makers should behave in a consistent manner whenever possible, even though they will have to pass up opportunities to confiscate revenue or manipulate economic outcomes in the short term.


Stephen M said...

An example today of time inconsistency, I think, is Chavez increasing suddenly without prior warning yesterday oil extraction fees for oil companies in Venzuela by a factor of 16.

Jake said...

The left believes that income taxes have no effect on behavior. That is true as long as the tax rates are low. But as tax rates rise, investments are made less for productive reasons and more for tax avoidance reasons.

Look at all the money that flowed into non-productive tax shelters from the end of WWII to Reagan’s tax cut. Then look at all the money that flowed into productive investments once the maximum tax rate was lowered from 70% to 30%.

The computer revolution in the US during the 80s and 90s occurred because Reagan’s tax cut released money to fund its research and development.