Ed Prescott, now at Arizona State but a professor in Minnesota's Department of Economics from 1980 to 2003, was awarded the 2004 Nobel Prize in economics together with Finn E. Kydland, Ed's student at Carnegie Mellon in the 1970s. The prize was awarded "for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles."
Time consistency in economic policy
The summary of their work that follows focuses on just half of the contribution recognized by the prize: the time consistency of economic policy. That work forms a backdrop to other important research done by Minnesota faculty that I hope to discuss in a future issue of Minnesota Economics.
When Kydland and Prescott started their work on the time consistency problem,2 they did not expect to conclude that macroeconomics up to that time was fundamentally flawed; they expected to add some refinements that would make the description of the economy internally consistent. They intended to work out how best to set government macroeconomic policy over time, taking full account of the microeconomic behavior of individuals and firms in the economy, and of how individuals would respond to macroeconomic policy. They thought that the problem would be hard, but solvable with standard mathematics developed for dynamic problems in engineering and physics.
To their surprise, they learned that there is a fundamental difference between studying dynamic systems in the physical sciences and in the social sciences: if you want to set a trajectory for a rocket to land on Mars as quickly as possible, you do not have to worry that your rocket might change its response to the laws of gravity half-way to the goal. But when you try to influence human behavior through government policy, you do. The issue of how individuals respond to policy is at the heart of the time consistency problem.
Time consistency in the familyWe understand this issue intuitively when it applies to our friends or family.
Imagine a father who threatens to spank a disobedient child. If the disobedience continues, the father may recognize that he does not really want to punish the child physically, and back down. After a couple of such episodes the child will see spanking as an empty threat, and pay no more attention. The father's policy is not time consistent. What looks like the best thing to do today when the threat is made won't look like the best thing tomorrow when the punishment is due.
There are two important considerations here. First, time consistency applies only when we look at changes over time--at dynamic rather than static problems. Second, unless you can find a strategy for precommitment that binds you to your policy--unless you are committed to following through and are willing to enforce the policy--it doesn't make sense to try to impose the policy in the first place. Perhaps grounding is the better way to punish the child if the parent is willing to carry out that threat, even though grounding is less of a deterrent than a spanking would be if the threat of spanking were consistently and thus credibly applied.
To see how precommitment can solve the time consistency problem, consider people who want to lose weight, or quit smoking or drinking, but can't do it. These people set a goal but keep postponing the hard work, or keep falling off their private wagon. Their problem is that they lack a commitment mechanism--an internal or external governor that will make sure that they stick to their plan. Emeritus Professor Herb Mohring faced the precommitment problem for weight loss, and solved it by making a bet with a friend over who would lose more weight over the next year. The loser would have to pay the winner $1,000, an amount big enough to keep both of them focused on their goal. (Herb won the bet.)
Time consistency in government policyGovernments face the same kind of problem. What at first seems to be an optimal policy today may not be time consistent, meaning that in the future, when it is time to do something that will impose a political cost on the government, that government will not want to stick to the announced policy. If there is no commitment mechanism to make the policy credible, people may see that the government will back down, and pay little or no attention to the government's pronouncements.
Consider the following two situations:
1) Buildings on a flood plain will sometimes flood, at large financial loss to property owners - added to loss of life and other human tragedies. A natural political impulse is to provide financial help to the property owners; if so, they face no incentive to rebuild on higher ground. A policy to refuse to help flood victims for their property losses would discourage rebuilding on the floodplain, saving lives and property; but when the next flood comes, the political impulse to give financial help will still be there. To be effective, the policy needs a persuasive commitment mechanism (a law forbidding building on the floodplain might work).
2) Once research and development (R&D) costs have been paid, a new lifesaving drug can be produced at low (marginal) cost. Full cost pricing that recovers the R&D cost will deny benefits to millions. Should we insist that the manufacturer make the drug available at low cost to save lives? Perhaps yes, if we focus on just the one drug--but what incentive will drug companies then face to seek still better drugs in the future?
Clearly a government policy that promises not to force drug manufacturers to sell below full cost would help, but will the drug companies find the policy credible? A body of legislation and consistent case law built up to protect drug patents may provide the needed commitment mechanism for a timeconsistent policy--but changing Medicare reimbursement rules or opening the market to imports from Canada could undermine the policy.
Macroeconomic policy faces the same kind of problem of time consistency and commitment. A monetary policy intended to prevent inflation becomes harder to maintain when current political pressures demand economic stimulus to get the country out of a recession. A central banker who succumbs to such political pressure will quickly teach financial markets that he is not capable of carrying out the antiinflationary policy, and those markets will demand higher returns to compensate for expected future inflation.
Designing the institutions to carry out a country's monetary policy requires a balancing act: freedom from political pressure on the one hand, in order to protect against subverting anti-inflationary policy, together with responsiveness to the market's demand that they focus on the inflation target.
Importance of the Kydland- Prescott contributionAs with many of Ed Prescott's contributions to economics, the years since the initial work on this issue have witnessed a dramatic change in the professional view of its significance--from denial that the phenomenon exists, to misdiagnosis of its cause, to widespread acceptance of the issue and understanding of its fundamental importance for economic policy. The Royal Swedish Academy of Sciences in its press release on the award said it this way:
"This research shifted the practical discussion of economic policy away from isolated policy measures towards the institutions of policymaking, a shift that has largely influenced the reforms of central banks and the design of monetary policy in many countries over the last decade."