October 11, 2006

2006 Nobel Prize in Economics.  The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel goes to Edmund Phelps of Columbia University.  In announcing the award The Royal Swedish Academy of Sciences honored Phelps for his work on “the intertemporal trade-off in macroeconomic policy.”  What that means in English is Phelps looked at trade-offs that take place over time in the setting of economic policy.

Most of the popular and business press have focused on Phelps’s development (at about the same time, but independently from Milton Friedman) of the expectations-augmented Phillips Curve in the 1960’s.  You might remember that the Phillips Curve argued that there was a trade-off between inflation and unemployment.  Low unemployment (which is good) brings about higher wages and thus higher inflation (which is bad).  While high unemployment (a bad thing) brings about lower inflation rates (which is good).

Phelps argued that this Phillips Curve trade-off between inflation and unemployment, if it exists, occur only the short-run when inflationary expectations are held constant.  In the long run, however, there is no trade-off as the economy moves back to its Natural Rate of Unemployment.

Thus, Phelps work helped to completely transform the way we think about monetary and fiscal policy.  Any attempt by policymakers to permanently lower the unemployment rate below the natural rate of unemployment will be inflationary.  Thus, policymakers should concentrate more on lower the natural rate of unemployment rather than attempting to stimulate the economy in the short run.

Other Intertemporal Trade-offs

While the Expectations Augmented Phillips Curve is important, I think it is also important to recognize Phelps’ other work.  Specifically, the committee noted his work on savings and human capital.

On savings Phelps took a unique approach at looking at the “socially optimal” level of savings.  That is, how much should we save?  Phelps argued that there is an optimal level of savings that will result in us being able to have the highest level of consumption in the future.  This he called the “golden rule.”

But he pointed out, often societies don’t save at the golden rule.  Some societies oversave and invest too much in the current period.  These economies will have trouble maintaining the capital stock in the future and thus have an unnecessary low level of consumption today.  An example of this would be the socialist economies of the 1960’s and 1970’s.  And, we all know how they turned out!  Phelps was right.

But…Phelps also pointed out that societies might save too little.  The problem he argued is that high levels of current consumption in one period come at the cost of lower consumption in the future.  An example of this would be if our children might consume a great deal it comes at the cost of our grandchildren.  Thus, if we care about our grandchildren we need to sure that our children save.

 Phelps also had a great deal to say about human capital.  He was one of the first to point out the economic advantages of early education.  He pointed out that it is the stock of human capital that is an important driver of economic growth not necessarily the increase in human capital.  The basic idea is that we it may take several decades for investment in education to pay off.  The money invested in education (especially primary education) will pay off in the future with a better educated workforce who then play an important role in technological innovation

What to take away from Phelps work.

Phelps’ major contribution was to make us think about the short run/long run trade-offs that exist.  Far too often today it seems we have forgotten what Phelps’ research has shown.  How often today do we think only about the immediate future? 

Think more about what Phelps had to say about savings and then think about the U.S. savings rate.  Do you care about the future generation?  Are you a parent?  Do you have nieces and nephews?  Do you understand what high levels of debt (negative savings) mean for those of the future generation?  Look again at Edmund Phelps’ work.

How often to policymakers (a group Phelps spent a great deal of time thinking about) worry only about the next few months, instead of thinking about the next few decades?  These policymakers all too often seem to forget about the intertemporal trade-offs, or the costs of actions today borne by those in the future.

Edmund Phelps has spent an entire career and was awarded the highest prize in economics by showing the danger of such thinking.

All the best,

MBrandl