Results for “thomas schelling”

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The most important application of the time-consistency ideas in Kydland and Prescott’s work (with due credit going also to Barro and Gordon and Kenneth Rogoff) is to monetary policy. Consider a central bank that wants low inflation and low unemployment. To keep inflation low the central bank promises to hold down the growth rate of money. Let us suppose that the public believes the central bank’s promise and as a result they plan on low inflation in their writing of contracts. At some point, however, unemployment will increase and the central bank will be tempted to juice the economy with a spurt of inflation. Since the public has planned on low inflation a higher than expected inflation rate will be very effective at reducing unemployment and thus very tempting.

But the situation that I have just described cannot be a rational equilibrium. When the central bank promises to keep inflation low the public will say, ‘this promise isn’t credible – if we take the central bank at their word they will surely try to deceive us later with high inflation rates’. As a result, the public does not plan on low inflation and when the central bank does want to reduce unemployment it must increase inflation even more than when low inflation was expected. The only equilibrium of this game is one with high inflation and no systematic reduction in unemployment.

How can we improve the situation? Surprisingly, a nasty central banker can make everyone better off. A nasty central banker cares only about reducing inflation and not at all about reducing unemployment (think fat-cat Republican living off fixed income bonds). Precisely because a nasty central banker won’t juice the economy to reduce unemployment, the nasty central banker can credibly commit to keep inflation low. The public believes the promise and safely plans for low inflation. Unemployment is the same in both scenarios – because the central bank can never systematically surprise the public with higher than expected inflation – but inflation itself is lower with the nasty central banker and thus the public is better off.

Thomas Schelling once described a similar idea this way: If you are kidnapped who do you want in charge of the negotiations, your loving wife or your nasty ex-wife? Easy, right? But suppose that the kidnappers know in advance who will be in charge of the negotiations – now who do you want? See? Sometimes, nasty people do good things.

This year’s Nobel Prize in economics went to Finn Kydland and Edward Prescott . Kydland and Prescott wrote a famous 1977 piece (Journal of Political Economy) on time inconsistency. Ever wonder why government policy toward prescription drugs is so problematic? Kydland and Prescott had the answer. The optimal policy will first award the drugmakers a patent and allow them to charge a high price. But once the drug is developed, the “rents” will be confiscated. Optimal policy will revoke the patent and lower the price. After all, once you have the drug. why not let everybody have it cheaply? Of course the drugmakers are aware of this danger in advance, and they are correspondingly reluctant to develop new drugs. Alex posted on this logic just days ago.

In more formal language, the optimal policy is not a time consistent policy. This develops earlier ideas from Thomas Schelling on game theory. Schelling’s point was that nuclear deterrence can fail because, once destruction is aimed your way, you don’t necessarily wish to retaliate.

The logic of time consistency is quite general. It applies to regulatory policy issues, tax policy, monetary policy, foreign policy (threaten Saddam, but do you really want to have go to through with it?), and strategic behavior in a wide variety of settings.

Here are my earlier comments on Prescott, which link to other facets of his work. He arguably has enough contributions to win the prize twice. Kydland is less well known but is an important figure nonetheless. And it doesn’t hurt that he is Scandinavian (Norwegian).

Are the pair deserving? Absolutely yes.

Why did they win this year? I’m guessing that in the midst of a partisan U.S. election, the Swedes did not want to pick Paul Krugman or Robert Barro (pro-Bush), for fearing of appearing too political. Note that the economics prize has stood under criticism for some time now, for not being “scientific” enough.

And this pick the betting market got right. Prescott had opened up a clear lead in the betting market some time ago.

Here is new information from the betting market. Ed Prescott has opened up a lead (then Barro, then Krugman), and Thomas Schelling has joined the list. Read my previous comments; the winner will be announced Monday.

As for tomorrow’s literature prize, John Updike, Margaret Atwood, and Philip Roth are the leaders.

Update: Here is the dark horse who won the literature prize, I am not a big fan.

Let us look at the betting market, as noted by guest-blogger Michael Stastny on his home blog Mahalanobis. The leaders are:

1) Ed Prescott – A powerhouse economic theorist. He has seminal insights into the role of “real” (i.e., non-monetary) forces in business cycles and whether returns on stocks (7% average) and bonds (a little over 1% on average) reflect the relative risk of these instruments. I am also a fan of his work on monopolies –often government monopolies — as barriers to innovation. His latest work suggests that Americans work more than Europeans because our marginal tax rates are lower.

2) Eugene Fama – His work on empirical finance tested whether the market rewards risk-taking and which variables might predict “excess returns.”

3) Gordon Tullock – My colleague, read my previous remarks.

4) Oliver Williamson – Asset specificity is his key idea. You invest in relationships with business partners and much of the value is specific to that relationship. Then things start going wrong…

5) Paul Krugman – Krugman winning the prize today would mean something very different than Krugman winning the prize five years ago. The chance of this happening is either much greater or much less than I think, I am simply not sure which.

6) Robert Barro – He has shown longer “legs” than his critics seemed to think he would. A powerhouse of macroeconomics and growth. It is less well known that he also did early versions of political business cycle theory and sticky price macroeconomics. I do not believe, however, that the Swedes will choose this year to reward someone who has to some (relative) extent defended Bush economic policies. (If you are wondering, Hans Blix is a heavy favorite to win the Peace Prize.) Barro is a very effective economic popularizer, in addition to his scholarly work.

7) Edmund Phelps – His work on labor markets laid the basis for the next thirty years of macroeconomics. He is not leading the betting market, but many observers consider him to be “due.”

Who is missing? Thomas Schelling is the most notable living theorist of spontaneous order and a key father of applied game theory. Like Phelps, he is “due.” Most of the people on the “New Candidates” list don’t have much of a chance, and here is a list of expired candidates.