Two economists known for their globally influential work on the forces behind economic booms and busts have won this year's Nobel Prize in economics, the Royal Swedish Academy of Sciences announced yesterday.
American Edward C. Prescott, 63, a senior monetary adviser at the Federal Reserve Bank of Minneapolis and a professor at Arizona State University, and Finn E. Kydland, 61, a Norwegian-born professor at Carnegie Mellon University, will share the $1.4 million prize, said the academy, which selects the Nobel Prize winners.
Prescott and Kydland collaborated on two key papers, published in 1977 and 1982, that focused on closely related issues. One was on the causes of "business cycles," or the economy's growth over time through a succession of expansions, recessions and recoveries. They showed how these cycles result from the collective decisions of consumers, businesses and economic policymakers, as well as advances in technology.
The second focused on the design of economic policy -- specifically the crafting of monetary policy to control inflation and influence economic growth through raising and lowering interest rates, and the shaping of fiscal policy to affect growth through federal government tax and spending decisions.
Prescott and Kydland showed that when government policymakers pursue stated goals inconsistently, it hurts their credibility with the public and can cause businesses and consumers to behave in ways contrary to those goals.
A central bank, for example, may say it is seeking to limit inflation but pursue policies that cause borrowers to expect that prices will rise. They are then likely to act on those expectations in ways that actually fuel price increases -- as happened in the United States in the 1970s.
Partly in response to such work, Federal Reserve policymakers have put a premium on managing expectations about inflation by constantly reaffirming their determination not to let inflation out of control. They do not want a false perception of Fed complacency to feed fears of rising prices, thus encouraging businesses to raise prices and workers to demand higher wages.
Prescott's and Kydland's work has "not only transformed academic research in economics, but has also profoundly influenced the practice of economic policy in general, and monetary policy in particular," the Swedish academy said in a statement.
The two men have worked closely together on and off for years. Both earned their PhDs in economics at Carnegie Mellon.
Prescott's research has focused on what causes economic depressions, why some countries thrive economically while others stagnate, and how nations boost productivity, or output per labor hour.
Kydland has done work on international trade and on how the money supply, or the availability of credit in an advanced economy, affects the business cycle.
Their work "reshaped the way all economists think," Kenneth B. Dunn, dean of Carnegie Mellon's business school, said in a statement.
"Ed has revolutionized the way we do macroeconomics -- here at the Minneapolis Fed and at universities across the globe," Ellen R. McGrattan, a senior economist at the bank, said in a statement. "In recent work, Ed asks, 'Why are Americans working much more than Europeans?' His answer is lower [U.S.] taxes. When I think about the many hours that Ed spends in his office, in the classroom and with his graduate students, I know the answer in his case is not lower taxes. It is his love of the science."
Neither professor responded to e-mails requesting comment. Kydland was teaching in Norway yesterday at the Norwegian School of Economics and Business Administration when an assistant interrupted the lecture to tell him he had won the prize, Bloomberg News reported. Prescott did not respond to a request by telephone for comment.
The two researchers' work was part of efforts throughout the economics profession in recent decades to explain the puzzle of the "stagflation" that beset the U.S. economy in the 1970s, when economic growth stagnated amid double-digit inflation and interest rates. That confounded the belief at the time that there was a trade-off between inflation and growth and that allowing inflation to rise a bit would enable unemployment to fall and growth to pick up.
Until the 1970s, the experience of the Great Depression and the work of economist John Maynard Keynes had led economists to see business cycles as essentially driven by rising and falling demand -- consumers' demand for goods and services and businesses' demand for labor, raw materials, equipment and other "inputs" used to produce goods and services. When demand slumped, so did economic growth and employment; when demand surged, so did growth and employment.
Consequently, most discussion of economic policy had focused on how to offset big swings in demand. The Fed, for example, would raise interest rates to fight inflation during a boom or lower them to spur spending during a recession. Or the federal government would increase spending or cut taxes to boost growth during a slump.
But the economic turmoil of the 1970s led to a rethinking of the old models. Many economists agree that the problems resulted from a combination of several events and policy mistakes, including fiscal policies during the Vietnam War that led the economy to overheat, monetary policies that allowed inflation and inflation expectations to take off, oil price hikes, and a sharp slowdown in productivity growth.
Prescott and Kydland made key contributions to this understanding first by showing that policy inconsistency can contribute to economic troubles. In the 1970s, for example, the Fed tightened and eased the availability of credit at various times, to combat inflation and slumps, but failed to thwart either. On the contrary, the Fed's mistakes made matters worse.
The two researchers also showed, importantly, that the strength of economic growth reflects changes not just in demand, but also in the supply of labor, materials and equipment, and particularly advances in technology. New technology can fuel growth by enabling business to operate more efficiently. Increasing productivity allows living standards to rise as businesses become more profitable and traditionally share a portion of the proceeds with workers and shareholders. Wages, stock prices and dividends can rise without driving up prices.
Prescott and Kydland's papers were written decades ago, but their observations were borne out in the late 1990s, when the economy boomed amid a spectacular gain in productivity attributed to advances in information technology.
Alfred Nobel, the Swede who invented dynamite, established the Nobel prizes for achievements in physics, chemistry, medicine, literature and peace through his will in 1896. The economics prize was created by the Bank of Sweden in 1968 in his memory.