October 12, 2004

American, Norwegian Win Nobel

Prescott, Kydland Honored
In Economics for Research
Crucial to Central Banking
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL

October 12, 2004; Page A2

An American and a Norwegian were awarded the Nobel prize in economics for research
that laid the intellectual foundation for modern central banking and for their somewhat
controversial work that redefined how some economists think about the causes of
economic booms and busts.
The award went to Edward C. Prescott, 63 years old, an economics professor at Arizona
State University and longtime researcher with the Federal Reserve Bank of Minneapolis,
and his frequent collaborator Finn E. Kydland, 60, a Norwegian-born economist now on
faculty at Carnegie Mellon University in Pittsburgh and at the University of California at
Santa Barbara. Mr. Prescott has long been seen as a favorite to win the award; Mr.
Kydland has received less attention.
The Royal Swedish Academy of Sciences said the men's work has "profoundly
influenced the practice of economic policy in general and monetary policy in particular."
The reforms that central banks around the world undertook in part as a result of their
work "are an important factor underlying the recent period of low and stable inflation."

The main insight came in a paper called "Rules Rather than

Discretion: The Inconsistency of Optimal Plans," written in
1977. In that paper, the authors examined how government
policy makers invited long-term trouble when they strayed
from their goals to address short-run problems. They applied
the theory to everything from patent enforcement to federal

disaster assistance, but it was in the area of central banking that the
ideas in the paper struck a chord. At the time, inflation was
running rampant and economic growth was stagnant -- a
phenomenon called "stagflation."
Most central bankers around the world typically espoused a
commitment to contain inflation, but in practice
central bankers would shift policy to tolerate a
little more inflation in the short run as a tradeoff for stronger economic growth and rising
employment. THEY ACT DOVISH - THEY
CAN'T HELP THEMSELVES! The professors
showed how these short-term shifts in policy
had long-term consequences and could push up
inflation expectations of households and
businesses, leading to long-running bouts of
rising prices.
"Kydland and Prescott's analysis provided an explanation for
the failure to combat inflation in the 1970s," the academy said.
The key to any policy, they argued, was to make a commitment
and stick to it. Central bankers responded by demanding more
independence, so that they would be less prone to interference
by elected officials who were concerned about short-term
fluctuations in the economy. It also led many central banks -such as those of New Zealand, Sweden and the U.K. -- to adopt
formal inflation targets to underline the commitment to low
inflation. "You should not think in terms of
controlling the economy," Mr. Prescott says. "That
leads to bad outcomes. You should think in terms
of committing to good policy rules."
Their research into business cycles has been more
contentious. Before the authors took up the subject
in a 1982 paper, many economists believed that

economic booms and busts were caused by changes in demand

by consumers and businesses, a point espoused by John
Maynard Keynes, whose views dominated economic thought
after the Great Depression. Mr. Keynes prescribed government
stimulus when consumer spending or business investment
softened.
But Messrs. Prescott and Kydland, who were the forefront of a
broad shift away from the teachings of Keynes, argued that
other factors, most notably a nation's productivity, were
critical driving forces in short-term shifts in the business cycle.
They theorized that supply-side shocks, such as a new
technological innovation or a surge in the price of oil, could
alter productivity patterns and cause a recession or an
economic boom. Before their work, economists thought
productivity of a nation's work force mainly affected long-term
economic performance.
Those views about the business cycle may seem
straightforward, but they remain contentious even today, in
part because they undercut arguments for the government to
act to stimulate demand when the economy weakens. Lawrence
Summers, the president of Harvard and the former U.S.
Treasury secretary, once wrote that the work of Messrs.
Prescott and Kydland on business cycles had "nothing to do
with the business-cycle phenomena observed in the United
States or other capitalist economies."SO, LAWRENCE
SUMMER IS MOST DEFINITELY A ___________ In an email yesterday, Mr. Summers said the two professors "richly
deserve" the prize because of the economic methods they
introduced, even though "I like many others find their
particular theories [about business cycles] implausible."
Messrs. Prescott and Kydland will share an award of 10 million Swedish kronor, or $1.4
million. The award is officially called the Bank of Sweden Prize in Economic Sciences in

Memory of Alfred Nobel. It is the last of six prizes announced by the Royal Swedish
Academy of Sciences; the others were all announced last week.
Write to Jon E. Hilsenrath at jon.hilsenrath@wsj.com3

Two majors points to emphasize: 1) Prescott and Kydland won noble prize for hands off
policy prescription; and 2) their work on real Business cycle analysis is contentious.
Applications to the Aggregate Supply / Aggregate Demand Model