The sort of economic work that wins Nobel prizes often is deemed esoteric but sometimes relates much closer to current events than one might think. Two very different items in the news this week relate to the work of Edward Prescott, who won the prize with colleague Finn Kydland in 2004.
The first item described the economic disruptions in Europe caused by ash from a volcano in Iceland and how these might extend over months if the eruption continues. This is an example of an “exogenous shock” as described by Prescott and others who worked on “real business cycles.”
Prescott, for 23 years a professor at the University of Minnesota and still affiliated with the Federal Reserve Bank of Minneapolis, was part of the Rational Expectations school within economics that rejected the prescriptions of John Maynard Keynes and his followers. The Keynesians advocated government manipulation of government taxes and spending and the money supply and interest rates to speed up or slow the overall economy.
The Rational Expectations group argued that such attempts at micromanagement were not only futile but ultimately self-destructive for an economy. But they had to come up with a solid explanation of why economies fluctuate in the first place. This had been a matter of debate for decades.
They found that cycles originate from developments outside the system, apart from government monetary or fiscal policies. Innovations in technology were the most important type of external shocks, but other sources were not ruled out. So if ash ejections continue and lead to slower economic activity in Europe this year, that is consistent with real business cycle theory.
Consistency itself is another element in Prescott’s work. He argued that if government policies were not consistent over time, they could be counterproductive. In particular, monetary policy had to be consistent to avoid inflation. Mere verbal commitments to low inflation were not adequate; what was needed was a track record of policies that fostered stable prices. This was best achieved by submitting the Federal Reserve to rules and not leaving key decisions to the discretion of chairmen like Ben Bernanke, Alan Greenspan or Paul Volcker.
This need for consistency relates to a second news item about Senate Minority Leader Mitch McConnell’s criticism of the Democrats’ financial regulatory proposals. McConnell argues that these proposals actually would encourage future financial bailouts. He wants a categorical commitment to no bailouts at all under any circumstances.
Whether this is a desirable goal is the subject of another column. The issue right now is whether such a policy would have credibility given the actions taken by the Bush administration and the Federal Reserve from August 2007 through the end of 2008.
Once we made the decisions to backstop J.P. Morgan’s takeover of Bear Stearns, to inject hundreds of billions into AIG, Fannie Mae and Freddie Mac, to create the fiction that large investment banks were really bank holding companies and to inject hundreds of billions in TARP funds into the largest commercial banks, our credibility goose was cooked for a generation.
We can say we will never do it again, but that stance is so inconsistent with what we have done that financial institutions will dismiss it as hot air and go on taking on risk, secure in the knowledge that any administration, Republican or Democrat, is more likely than not to cave the next time the chips are down. Goldman Sachs’ newly announced profits stem exactly from such willingness to take on risk under the umbrella of implicit government guarantee.
Just as it is difficult for any president of Argentina to be credible on either fiscal or monetary discipline, given that country’s history, it will be difficult for our own nation to enforce any sort of “never-a-single-bailout-again” stance, no matter how loudly we say it. And Ed Prescott’s work explains why.
(Note that the above is my own application of Prescott’s work to current news. It is not intended to convey his views on these specific matters. My hunch is that he has nearly as many objections to the Democrats’ proposed financial regulation as does Sen. McConnell, even though for different reasons.)
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.