October 27, 2004

When the Nobel laureates in economics for this year were announced, I immediately thought this would be another year when I did not know who the recipients were and what they did.  Until two years ago, I was aware of some work by each economics Nobel laureate that had been picked since the prize began in 1969.

However, while I knew about the experimental economics studies that began about 15 years ago and are important at Georgia State University, which has a very well developed experimental lab, I did not know the important contributors to that process who were honored two years ago. 

I originally thought that this year’s award to Edward Prescott and Finn Kydland would be another recognition of new economic ideas whose founders went beyond my expertise.  Then I realized that I had used an article co-authored by them on the “real business cycle” in my class on economic dynamics.  I had thought the article was interesting but wrong 

Beginning at the economics convention held in Atlanta in 1979, economists began to question the separation of economics into aggregates, such as consumption and investment, on the one hand, and individual choice and the response to price behavior in individual markets on the other.  Instead of saying there is something that explains consumption, economists began to say if we added up all the individual decisions of households trying to make reasonable economic choices, how much would they consume? 

Some of my readers who had economics in college before the mid 1980s would be shocked to learn that this method of thinking brought the theories of John Maynard Keynes and Milton Friedman together as two examples of markets out of equilibrium.  They were both special cases of market conditions that were inconsistent with households and corporate leaders making reasonable economic choices. 

A few years ago, George Akerloff and Joe Stiglitz received Nobel recognition for uncovering why those disequilibrium special cases in theory were relatively frequent in fact.  Therefore, traditional policy methods of dealing with imbalances had merit according to their works.

Furthermore, the Prescott and Kydland group, who became known as neo-classical, were having trouble showing how reasonable individual decisions could spawn economic cycles.  If everyone was making appropriate decisions based upon available economic information, how did we get “mistakes” that led to economic downturns. 

In the paper I used for my class, Prescott and Kydland argued that unexpected supply shocks, such as a shift in the market structure of oil (e.g. the 1973 boycott or the 1979 Iranian revolution) caused the past information to be inappropriate, leading to wrong decisions.  This information failure was then transmitted through a process based upon behavioral and institutional barriers that prevented immediate adjustment to the new reality. 

Instead of using some temporary measure to bolster purchasing power and spending during this adjustment process (we call them recessions), policy should work upon avoiding the supply shocks to the extent possible ( but how do you stop a revolution) or changing the behavioral barriers. 

Actually, this thinking led to readjustments of monetary policy in South America and Eastern Europe that have substantially eliminated the previous bouts of hyper-inflation and their economic distortions.  Because Prescott’s work, in particular, provided the backbone for national central banks to alter their inflation bent policy, he certainly has contributed to economic well-being.  Not many economists can have that said about their work. 

Unfortunately, China also is following similar monetary principles.  To insure predictability in the purchasing power of their currency, they effectively have borrowed the history of another, the dollar.  This worked for Bulgaria and may have aided the price stability of Argentina (although Argentina suffered a serious recession in initiating the dollar based peso).  In China, competitiveness has become so altered by the falling dollar that serious world distortions in industrial structure may be developing.

So what is wrong with Prescott and Kydland’s papers on “real business cycles.”  As George Akerloff showed in his auto lemon paper, price denotes more than scarcity. 

Harvard business school has an “urban myth” (something assumed to be true but no one knows why) about students who discovered a synthesized perfume that was so well done that no consumer testing could differentiate between it and the $30 per ounce real stuff.  It cost about $1 to make.  They put it on the market at $5, a very profitable mark-up, and it failed. 

Another group of students bought the rights to the production process, sold the perfume at $25 and they made millions.  The moral:  price not only reflected economic costs, but also product quality.  At $25, customers assumed it was the good stuff at a bargain.  At $5 they knew it was synthetic, which meant cheap and not worth a try. 

By failing to understand the dual role of price, consumers will periodically make purchasing errors that will lead to economic distortions requiring recessionary adjustments.  That is not permitted in the Prescott and Kydland process. 

Nevertheless, the “real business cycle” is a major economic effort in macro-economics that deserves the recognition it received with the latest Nobel awards.  That only economists can understand the true importance of this effort should not diminish its significance.


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