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October 17, 2004
David Warsh, Proprietor


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A Day in the Life of Ed Prescott

Back in 1968, molecular biologist James D. Watson electrified a notable portion of the reading public with a memoir he called The Double Helix: Being a Personal Account of the Structure of DNA, a Major Scientific Advance Which Led to the Award of a Nobel Prize. The book was remarkable not just for the candor — its working title, before it was rejected by Harvard University Press, was “Honest Jim” — but for the clarity with which it explained the then-unfamiliar world of molecular biology, and for its graceful prose.

There’s a piece of writing about economics nearly as good as Watson’s in Lives of the Laureates, a collection of autobiographical essays by 18 Nobel economists (out of 55 possible lives), edited by William Breit and Barry Hirsch.

Robert Lucas’ memoir is not as nearly as long — only 25 pages. Nor is it in any sense complete. It touches only on one series of episodes in Lucas’ long career. (It seems to be part of a longer work in progress, but it will be years before that work appears, if it is to appear at all.)  But it illuminates particularly brightly some of the events surrounding the award last week of the Nobel Prize to Edward Prescott and Finn Kydland.

Prescott and Kydland are not among the better known figures in economics, at least to outsiders.  Kydland, a Norwegian citizen, has taught at Carnegie-Mellon University since 1978 (though this year he is on leave at the University of California at Santa Barbara, and was lecturing in Norway when he got the news). On the eve of his apotheosis, Prescott was lured away from his long-time home at the University of Minnesota by the Arizona State University, in Tempe.

Prescott himself is hard to read; for most people, he can be harder still to talk to. But for thirty years, he has been among the foremost contributors to the swirling controversies over the legacy of John Maynard Keynes in macroeconomics. And he and Kydland are authors of one of the single most important building blocks of economic policy of recent times.

Back in the 1960s, students of economics learned about the Phillips Curve, the hypothesized tradeoff between inflation and employment which suggested that a little more inflation would mean a little less unemployment. The Phillips Curve implied a big role for government in managing the economy.

The idea that the relationship could be depended on to hold up over time was criticized by Milton Friedman and Edmund Phelps, but there was no real alternative to it — no analytic device to put in its place

Then in 1977 Prescott and Kydland published “Rules Rather than Discretion:  The Inconsistency of Optimal Plans” in the Journal of Political Economy — 28 pages, most of them densely mathematical.  Only slightly less abstruse was the label that evolved to describe the problem they diagnosed: “time inconsistency.”

Prescott later explained that he and his former student originally wanted to make a general point about the reason that policymakers’ good intentions could go awry if they responded to problems as they arose, instead of steering for a distant target. It was to have been an all-purpose warning against the problems that arise from public expectations of government bailouts. The editor insisted that they present a concrete example.

So they showed how monetary surprises could feed back into the real world of jobs and prices, leading to further monetary shocks, until high inflation that had been no part of the original intention to alleviate unemployment became the inevitable result. Nor, in the end, would the unemployment rate decline.

Other economists quickly built on their insight, moving fairly directly to the idea of setting inflation targets and to be pursued by following certain well-defined and widely announced rules. “Credibility” became a new key word in economists’ vocabulary.

Because central bankers play by these very different rules now, there is broad agreement among monetary economists that today’s inflation rates are far lower and more stable than what they were in the past.

The entire edifice is built firmly on Lucas’ and several others’ success in building a way of describing how people think about the future into formal economics — the assumption of rational expectations.

Most prominent among those others were Prescott and Kydland; John Taylor, Stanley Fischer and Rudiger Dornbusch; Thomas Sargent and Neil Wallace.

And what exactly was involved?  As Lucas once explained it (in Michael Parkin’s fascinating introductory textbook), rational expectations is a shortcut, a compressed future-perfect view of the world. “[It] describes the outcome of a much more complicated process. But it doesn’t describe the actual thought process that people use in trying to figure out the future. Our behavior is adaptive. We try some mode of behavior. If it is successful, we do it again. If not, we try something else. Rational expectations describe the situation when you’ve got it right.”

Lucas gives a good account of the evolution of his thinking in his essay in Lives of the Laureates.  It is much too complicated to give more than a taste of its flavor here.  But Prescott is a central player in the story.  Lucas describes the steps in his gradual evolution — the result of interactions with a couple dozen other very good economists — from an econometrician working on standard Keynesian problems to an iconoclastic theorist and leader of a “new classical” movement that would banish from economics’ foreground not only Keynes, but Milton Friedman as well.

He picks up the new mathematical tools that economists were adapting from rocket scientists in the 1960s to tackle their various planning problems — the calculus of variations, Pontryagin’s maximum principle, Bellman’s dynamic programming. With Prescott, he tackles the highly mathematical competitive general equilibrium theory of Kenneth Arrow, Gerard Debreu and Lionel McKenzie.  They come away with a series of practical applications of high theory that no one had imagined might exist. Together, Lucas and Prescott write the 1972 seminal paper — “Investment under Uncertainty” — that creates the tools with which all the rest will be built

Twenty years later, Olivier Blanchard of the Massachusetts Institute of Technology would describe the revolutionary change they engineered: “Until [the late 1970s], macroeconomic policy was seen in the same way as a complicated machine. Indeed, methods of optimal control, developed initially to control and guide rockets, were being increasingly used to design macroeconomic policy.” Economists were creatures of their tools.

“Economists no longer think this way. It has become clear that the economy is fundamentally different from a machine.  Unlike machine, the economy is composed of people and firms who try to anticipate what policymakers will do, who react not only to current policy but to expectations of future policy. In this sense macroeconomic policy can be thought of as a game between policy makers and the economy. Thus when thinking about policy, what we need is not optimal control theory but rather game theory.”

In his memoir, Lucas describes the shift in his perspective that he was working, step by step, to express:

“In 1963, I had thought of a competitive industry in terms of firms solving short- and long-run, deterministic profit-maximization problems, under the (false) belief that current prices would maintain their current values forever, and with the passage from one to the other and all the effects of unpredictable shocks tacked on as an afterthought.

“Five years later, I thought of the same economics in terms of firms maximizing expected discounted present value, with rational expectations about the probability distributions of future prices, and with stochastic shocks and adjustment costs both fully integrated into the theory.

“From an objective point of view, this transformation can be viewed as a product of decades of research by many economists. From my subjective viewpoint, it was the most rapid, radical change of view I have ever experienced as an economist.”

At another point, Lucas describes a representative moment in his and Prescott’s working lives. They had finished “Investment under Uncertainty.” Prescott had moved back to Carnegie Tech where Lucas was teaching. (This was before Carnegie Tech became Carnegie-Mellon University.)

Lucas was working on unemployment.  The model on which he was working had workers distributed over a large number of distinct markets, all of them subject to persistent ups and downs in demand “If your market is hit with a bad shock, wages are likely to be low for a while. You are tempted to leave, to set out for brighter prospects elsewhere, but this will entail a spell of unemployment. The risks must be balanced and how this balancing comes about depends on what everyone else is doing.

“After some weeks, I felt I was very close to having a successful mathematical model of this situation…” The idea was very close to what Milton Friedman had called “the natural rate of unemployment.”  But the pieces refused to fall into place.

So Lucas explained the problem to Prescott one Friday afternoon, asking him to join in. Suddenly, in a phenomenon that is common among researchers, he feared that he had told too much; that Prescott would be tempted to take the problem over and publish it by himself, and not so much acknowledge in his opening footnote the “useful discussion” he had had with Lucas. So over the weekend, Lucas wrote up as much of his model as he could, and on Monday handed Prescott the draft.  They began talking.

Before long, Lucas writes, it was clear that the approach which he thought was so nearly complete was flawed.  Some propositions were clearly false and others were far from proved.  Days passed, he says, perhaps weeks. And then one morning he came to work and found in his mailbox a note from Prescott:

“Bob,

This is the way labor markets work.

v(s,y,λ) = max{λ,R(s,y) + min [λ,βº v (s’,y,λ)f (s’,s)ds’]}.

Ed”

Lucas and Prescott already had agreed on some notation: s stood for the state of product demand in a particular location, y stood for the number of workers who were already at that location, R(s,y) was the marginal product of labor implied by those two numbers, and v(s,y) stood for the present value of earnings that one of those workers could obtain if he made his decision whether to stay at this location or leave optimally.

He writes, “Other features of the equation were as novel to me as they are (I imagine) to you.”

“The normal response to such a note, I suppose, would have been to go upstairs to Ed’s office and ask for some kind of explanation. But theoretical economists are not normal, and we do not ask for words that ‘explain’ what equations mean. We ask for equations that explain what words mean.

“Ed had provided an equation that claimed to explain how labor markets work. It was my job to understand it and decide whether I agreed with this claim. This took me a while, but I saw that Ed had replaced an assumption of mine that workers who leave any one location hit on a new location at random — maybe a worse location than the one they had left — with the alternative assumption that searching workers were fully informed about options elsewhere and bee-lined for the best destination.

“Mathematically, this meant that a single parameter — Ed’s λ — stood for two different things:  the present value of earnings that all searching workers would have to expect in order to leave a location and the present value that a particular location would need to offer to receive new arrivals.

“Mathematically, Ed’s equation was a very familiar, comfortable object for me to analyze; once I convinced myself that it described some sensible economics, it took a few minutes for me to see its properties could be established by standard methods and that these properties were interesting and reasonable.  By lunchtime I could see that I was to be a co-author of a very sharp paper, unlike anything anyone had seen before, a paper with the potential for helping us think about important events.

“If I had to pick a single day to represent what I like about a life of research, it would be this one.  Ed’s note captures exactly why we value mathematical modeling:  it is a method to help us get to new levels of understanding the way things work. No one could have written Ed’s equation down at the beginning of an inquiry into the nature of unemployment: it is too far from earlier ways of thinking to be grasped in one step.

“The new understanding that the equation represents could be gained only through a trial-and-error process, involving formulating and analyzing explicit models. It is this struggle to capture behavior in tractable models that leads us deeper into the economics of market interactions and forms the progressive element in economic thought.”

The resulting paper, “Equilibrium Search and Unemployment,” is not one of Lucas and Prescott’s most important, though it led on to another skein of important work. It is not one of those papers for which either won the Nobel Prize. And of course the collaboration between Lucas and Prescott reflects only in the most general way on the collaboration between Prescott and Kydland that is the at the center of this year’s Nobel prize.

But Lucas’ essay in Lives of the Laureates explains as well as anything that I have ever seen what it is that mathematical economists do together. There is plenty more of the story to tell. Let us hope that this is the first of several chapters.

Prescott has become involved in other economic controversies. He was a major player in real business cycles, a duller subject for another day. And when attention shifted to a much more interesting topic, economic growth, Prescott went there too. Barriers to Riches, his 2000 book with Stephen Parente, is a celebration of the mathematical modelling conventions of perfect competition. (“There is no reason why the whole world should not be as rich as the leading industrial country.”)

Recently Prescott been writing about why the French work so much less than the Americans (never mind French culture, he says, the reason is high taxes) and whether to stock market gets the value of American corporations about right or not. It is fairly orthodox price theory, aggressively applied. Now that he has been blessed by the Swedes, you can expect to see Prescott in the newspapers more often.

But in 1977, once and for all, Prescott and Kydland demonstrated that, in the game of monetary policy, sometimes you can do better if you give up some of your options and credibly commit yourself to a certain course of action — or inaction — from the start.

The clever editorial writers at The Financial Times last week compared “time consistency” to Odysseus’ famous trick of putting wax in the ears of his oarsmen and lashing himself to the mast, thus hearing the Sirens’ beautiful song, without commanding his boat to steer into the rocks, or throwing himself into the sea.

Rarely has an important paper in technical economics had a more accessible title than “Rules vs. Discretion” — or a more substantial worldwide policy payoff in real time. That is why Prescott and Kydland received their Nobel Prize.

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