Business cycles and free markets: A critique of Kydland and Prescott

15 October 2004 The Hindu Opinion - Leader Page Articles Business cycles and free markets By Siddharth Varadarajan The contribution of Professors Kydland and Prescott, who won the Economics Nobel this year, was to reconcile the empirical reality of recessions with the assumptions of New Classical economics. IN AWARDING the Nobel Prize for economics this year to Edward Prescott and Finn Kydland, the Bank of Sweden has honoured a body of work that seeks to answer one of the fundamental paradoxes of `New Classical' economics. This is the presence of cyclical fluctuations in output and employment that persist, often for long periods of time, despite the supposed efficiency of market forces. Business cycles have been with us as long as capitalism has. Their explanation does not pose a particular theoretical challenge for either Keynesian or Marxist economists, who, to varying degrees, consider periodic crisis to be endogenous to the system. But for the New Classical economists who currently dominate the economics profession, the persistence of unemployment in a recession does not sit well with the comforting assumption that prices and wages automatically adjust to return an economy to "equilibrium." The issue is one of politics and not merely logical consistency. For, unless this paradox is resolved, it is difficult to defend the fiscal and monetary conservatism that has become the defining feature of the ruling policy dogma. New Classical economists like Robert Lucas took from the classical tradition the belief that markets are efficient and added the assumption of "rational expectations" — that the outcome of any given economic event such as a policy change does not differ systematically from what individuals and firms expected it to be. In such an environment, increasing government expenditure to reduce unemployment below the "natural rate" or expanding the money supply has no effect on the real economy. The conclusion: budget deficits are verboten and monetary policy has to be left in the hands of an independent central bank insulated from democratic control and wedded to a predictable pattern of behaviour (`rules' rather than `discretion', to use the terminology of a seminal 1977 article by Professors Kydland and Prescott) aimed at keeping inflation low no matter how high unemployment may rise. Recessions, in this fairytale world, occur only because of "temporary confusion." The contribution of Professors Kydland and Prescott was to reconcile the empirical reality of recessions, which lasted too long to be considered the product of "temporary" confusion, with the assumptions of New Classical economics. In their 1982 version of a class of models known as "Real Business Cycles", capitalist economies are subject to exogenous shocks — typically technology shocks which affect labour productivity. "If a shock shifts the constant growth rate down, the economy responds as follows: market hours fall, reducing output, a bigger share of output is allocated to consumption and a smaller share to investment, and more time is allocated to leisure," Prof. Prescott explained in an article on the Great Depression in the Federal Reserve Bank of Minneapolis Quarterly Review in 1999. "Over time, market hours return to normal", helping the economy converge to a new equilibrium. Recessions, thus, are the rational (`pareto-optimal') product of utility-maximising individuals. "The Keynesians had it all wrong," he wrote. "In the Great Depression, employment was not low because investment was low. Employment and investment were low because labour market institutions and industrial policies changed in a way that lowered normal employment." Here, the entire model pivots around the notion of "intertemporal labour substitution." In plain English, the argument is that when wages fall, workers substitute leisure for labour. This "preference" for leisure resolves the unemployment paradox for New Classical economists because it suggests the unemployed are not really so. They are merely taking time off. Willem Buiter called this reasoning the `economics of Dr. Pangloss', the reference being to the philosopher who kept telling Candide whenever disaster struck, "Surely this is the best of all possible worlds." Paul Samuelson, in a 1998 lecture, was equally withering. "The phoenix of Real Business Cycles has been whistled up anew... What is new, and a little foolish, is the concept of a Pareto-Optimal real business cycle, like the one not in the history books, where at one time in 1929, folks everywhere developed a desire to substitute leisure for good paychecks." Critics have punched other holes in real business cycle theory. Prof. Prescott says his model accounts for 70 per cent of observed post-war fluctuations in the U.S. economy. In a 1996 interview, Prof. Prescott was asked to point to specific technological shocks that led to specific recessions. "Can we identify specific shocks," he replied. "My answer is no." Instead, he said his theory was really that business cycles are "the result of the sum of many random causes." At the end of the day, then, the `real' business cycle model seems to possess as much explanatory power as the mathematically less elegant theory of Stanley Jevons in the 19th century that economic fluctuations were caused by sunspots. Today, most economies, including India, are beset by a number of problems — jobless growth, structural unemployment, rising inequality, periodic overproduction and insufficient demand. The very persistence of these problems suggests the causes are not random, or temporary or exogenous, but endemic. New Classical economics offers us no answers. Its chief policy prescription — that the state should let the economy take care of itself — has little relevance for advanced industrial countries. In India, this suggestion is positively dangerous. © Copyright 2000 - 2005 The Hindu