Presentation Speech by Professor Jörgen Weibull of the Royal Swedish Academy of Sciences, December 10, 2004.
Your Majesties, Your Royal Highnesses, Ladies and Gentlemen,
Brilliant scientific insights change our outlook on the world so that, as time goes by, we come to regard them as obvious. At first, however, the new ideas may appear foolish, particularly when they contradict the predominant view. This year’s Laureates in Economic Sciences have seen their ideas make the journey from the foolish to the obvious – not only once, but twice.
The predominant view of business cycles and economic policy during the first half of the 1970s relied on Keynes’s ideas and experience from the severe crises in the 1930s. In this view, business cycles could always be stabilized by government authorities. They should have full discretion, for instance to choose lower unemployment at the expense of higher inflation. Researchers could use so–called business–cycle models to provide underpinnings for such decisions by showing how inflation and unemployment were affected by lower interest rates or higher public expenditure.
The stable economic growth in the Western world during the 1950s and 1960s appeared to confirm this set of ideas. But the turbulent economic environment of the 1970s was an unwelcome wake-up call. Previously robust relationships in business-cycle models broke down. Economic policy failed and resulted in stagflation – concurrent inflation and unemployment. Researchers had indeed identified the shortcomings of their approaches, but there did not seem to be any feasible alternatives.
Among these frustrated researchers was Finn Kydland, who had recently received his Ph.D. and taken a job at the Norwegian School of Economics. When his advisor from Carnegie Mellon, Edward Prescott, was in Bergen as a visiting professor, the two entered into a rewarding collaboration. In 1977, the duo demonstrated – contrary to prevailing theory – that society could gain from prior commitment to economic policy. The origins of this startling conclusion lie in households’ and firms’ expectations. The article showed why decision-makers with complete short-run discretion to vary interest rates and expenditures are often unable to credibly announce, and adhere to, a desirable long-run policy. This time consistency problem provided a common explanation for phenomena which had hitherto been interpreted as disparate policy failures, for example the inflationary spirals in Western economies as of the mid–1970s.
The Laureates’ work has stimulated new and extensive research on what types of policies are credible and politically feasible, questions which earlier analyses had never even posed. As a result, the entire discussion of economic policy has shifted from isolated measures to policymaking institutions. Practical examples include reforms of central banks and budget processes in many countries, including Sweden, over the last 10–15 years.
One summer, a few years later, Kydland and Prescott returned to Bergen, where they initiated a new project on business cycles. In 1982, they once again published results which reverberated throughout the academic community. According to established theory, variations in demand drove business cycles, but the Laureates pointed to driving forces on the supply side of the economy. They had in mind not only the oil-price shocks and productivity slowdown of the 1970s. Their new results revealed that fluctuations in the growth rate of technology could explain most of the postwar pattern in U.S. business cycles. Later on, the IT boom of the 1990s turned out to be an explicit example.
This analysis was unique also in other ways. Business cycles were the cumulative result of innumerable forward-looking decisions in households and firms, coordinated by wages, prices and interest rates. Such microeconomic foundations provide more robust results than earlier models, where the relationships were formulated at the macro level. Another novel feature was the method to calibrate a model with information from micro studies and generate synthetic time series for important macro variables by simulation. The model became a laboratory for large-scale economic experiments.
Dear Professor Kydland, Dear Professor Prescott,
At first, many economists found your ideas about economic policy design and the driving forces behind business cycles quite foolish. After passing this first test of a brilliant insight, most of your ideas have also passed the second test. Commitment vs. discretion in economic policy and cycles driven by supply as well as demand shocks are obvious to economists of today, as is the value of microeconomic underpinnings for quantitative macroeconomic modeling. Your work opened up far-reaching fields of research. It also changed our outlook on economic policy and the practice of institution design, especially in central banking.
It is a great honor and a privilege for me to convey to you, on behalf of the Royal Swedish Academy of Sciences, our warmest congratulations. I now ask you to receive your Prizes from His Majesty the King.
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