Lessons from a Nobel laureate

Philippine Daily Inquirer, February 11, 2008

THE PHILIPPINE ECONOMY COULD HAVE been growing at eight percent or more now if not for inconsistencies in economic policy that have beset our country over recent years.

“This is the influence one could get from the work that won the 2004 Nobel Prize in Economics for Prof. Finn Erling Kydland, a Norwegian economist now teaching in the University of California at Santa Barbara.

Professor Kydland was in town last week, and gave a public lecture to a packed audience at the AIM and the University of San Carlos in Cebu.

He was here under the program called “Bridges-Dialogues Towards a Culture of Peace,” which brings Nobel Prize winners of various disciplines to countries in the developing world to benefit from their wisdom.

Expect more Nobel laureates to come to town under this program in the weeks and months ahead.


What earned him the Nobel Prize jointly with his academic advisor at Carnegie Mellon University, Edward c. Prescott, was their work on real business cycle theory and time inconsistency in economic policy.

He and Prescott studied the driving forces behind business cycles, which we described recently (“Will we import a US recession?,” NFL 1-28-08) as periodic cycles of upturns (growth booms) and downturns (recessions) that appear to come with inevitable regularity due to the inherent workings of natural economic forces.

To Kydland and Prescott, the upturns and downturns originate from random shocks on productivity of the economy, such as technological innovations, bad weather, spikes in the price of imported oil, or changes in economic policy.

Their theory is built on the arrangement that people-both as consumers and producers-behave optimally and rationally in response to economic circumstances to pursue what is best for them.

For example, an oil price spike would lead them to cut down on activities that use oil, including production of energy-using goods and consumption activities that use oil, like traveling. Discovery of a productivity-raising technology will draw greater investments into that production process. And so on.

Business cycles occur as a natural off shoot of people's optimal response to these random shocks described above. But precisely because people react "correctly" to these shocks and the ensuing economic trends, there is a self-correcting nature to the upturns and downturns.

Hence, a downturn must eventually turn up again, and vice versa what many like to call the "law of gravity" in business cycles.

Discretionary policies by the government that try to counteract these shocks in the short term can, and often, make things worse in the long term, because they complicate and undermine people's optimal reactions to the shocks.

Thus, the best policy, Kydland and Prescott argue, is to stick to long-term policy directions that have been set beforehand. Governments are better off conducting economic policy based on set directions and rules (based on a well-defined vision and strategy), rather than discretion.

One practical implication of this is the desirability of having an independent monetary authority, which has led most countries: including the Philippines, to ensure independence of their central banks from government decision-makers.


It was no surprise, then, that Professor, Kydland's widely-quoted response to a question on what the Bangko Sentral must do to respond to the US subprime crisis was: "Hardly anything.” What he really meant, based on their theory, was that BSP should not even do anything-or at least, anything that attempts to directly respond and react to the US developments.

Even within the United States, many are arguing that the markets are simply "punishing" those players (e.g. banks) who made inappropriate moves in the past.

Undertaking measures that would serve to lighten that punishment, such as what the Fed has been doing by lowering interest rates, may only reinforce those mistakes, and may make things worse in the long run, as the argument goes.

Our own experience over recent years has been exactly contrary to what Kydland's theory would prescribe. Many have lamented how the current leadership has lacked a clear vision and strategy on which to base a clear policy direction to begin with.

Worse, policy reversals and inconsistencies have marked the current administration's (mis)management of the economy, not because we have bad economic managers, but because directions set by the competent economic managers have constantly been thwarted by politically-motivated policy reversals from the Palace.

Kydland shared finding that Argentina could have attained even higher rates of economic growth in its boom years in the 1990s, if not for a past history of policy moves that undermined government's credibility to investors.

In the same vein, our reported 7.3 percents GDP growth last year could have been significantly higher had private investments not been as sluggish as they have been.

And as I often lament in this space, what has kept those investments that way-to adapt the famous Clintonesquequote- boils down to one fact: It’s the governance, stupid!

The next Ateneo Eagle Watch Economic and Political Briefing will be on the morning of Feb 20 at the Ateneo Rockwell campus. Email Guia Janson at majen83@gmail.com for inquiries and reservations. Comments are welcome at chabito@ateneo.edu.