Well deserved prize

It has been some time since the Bank of Sweden Prize in Economics, which is awarded by the Nobel Prize committee, has gone to economists who have actually dared to blow a raspberry at the prevailing orthodoxies of macroeconomics.

So even though not many people may have heard of Finn E Kydland, and Edward C Prescott, a Norwegian and an American respectively, the fact is that their work will (or should) make policy makers sit up and take notice.

In a nutshell, their work has sought to prove that fluctuations in economic activity take place because of an aggregation of random events, some of which might even be shocks such as technology shocks. As such, monetary and fiscal policies are useless in doing anything about reducing output when the economy is overheating and vice versa.

They also showed that such fluctuations are not particularly costly to society and that, all things considered, the economy responds almost optimally.

Larry Summers, who was then a professor at Harvard, was scathing. "My view is that real business cycle models of the type urged on us by Prescott have nothing to do with the business cycle phenomena observed in the United States or other capitalist economies."

Thus, until now, the high priests of orthodoxy had dubbed them as virtual heretics. But the now that the Nobel Committee has conferred sainthood, they will have to be accommodated in the pantheon.

Their most noteworthy paper, however, appeared in the Journal of Political Economy in 1977. It was called "Rules Rather Than Discretion: The Inconsistency of Optimum Plans." It is one that our Communists must be made to read.

In that paper, the two pointed out, very convincingly, that the best policies always suffer from a major flaw: after a while everybody agrees that there is a better way of doing things. But""and here comes the kicker"" if people can't agree on the original plan, the newer best plan is also not feasible.

In other words, what is good policy now may not be good policy in the future. A large public sector financed by high taxation was a good idea then but is no longer so.

So what should governments do? The answer, say Kydland and Prescott, lies in institutions sticking to the rules and not making them up as they go along. That way lies disaster, as we have seen in India.

Prescott also believes that the most important question facing economists is "Why isn't the whole world rich?" Accumulating physical and human capital is all very well, he has said, but in the end harnessing these to best use depends on the rules of the game which determine total factor productivity.

To quote him, "What we should be worrying about is increasing the average rate of increase in economy-wide productivity and not smoothing business cycle fluctuations."

To the extent that it is only owners of capital who want to prevent fluctuations, and therefore the sizes of the fortunes, this is pretty close to what the Left the world over has been saying but without such clarity. Or are we reading the Nobel tea leaves wrong?