Dr Wangari Maathai has been awarded the Nobel Peace Prize for 2004. She has been very active in promoting ecological development (perhaps "rehabilitation" would be a better word) in its wider social, economic and cultural sense, with most of her work taking place in Kenya and Africa where she founded the Green Belt Movement (GBM) which mobilised women to plant 30 million trees.
The GBM is involved in various areas including environmental and civic conservation and education, training and "Women for Change". They want to leave behind them a nobler world.
In a way, this year's prize winners in economics wish for a nobler world as well. Seeing how the world - rather, the people in it - often glorify the bad and denounce the good, I would not be too surprised if, down the line, we would see movies with terrorist heroes and none at all about people who dedicated their lives to improving others' lot.
There are already people who say that Nazi atrocities did not take place and, if just now you recalled A Beautiful Mind, it would probably not have been made had John F. Nash not had such a colourful life, and mind, and few would be the wiser about Nash equilibria, even though in the movie the economics did not come through.
The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2004, which is the full name of the Nobel Prize in economics, went to professors Finn E. Kydland and Edward C. Prescott "for their contributions to dynamic macroeconomics - the time consistency of economic policy and the driving forces behind business cycles".
Let us start with the second area of their work. In order to understand the importance of the laureates' work in this area, one has to appreciate the structure on which economists studying business and economic cycles used to hang their thinking.
I will here simplify, but one can say that there are two main schools of economics. The first follows the teachings of John Maynard Keynes and is generally favoured by people who believe that the best way to improve the world is to manage it - I am not referring here to improving one's life by managing one's life (a basic right), but to improve the general lot of humanity by having one central authority which manages the driving forces in the economy. If demand is weak, the government would start spending so that people have more money in their pockets and buy more.
The other school, the monetarist, represented by Milton Friedman and Friedrich Hayek, focuses on letting the market free (as much as possible) and restricts economic interference to ensuring stability, for example by controlling the amount of money made available in order to avoid inflation.
One would at first think that the idea of a controlled economy is passé, that it lost all its disciples, but it is actually alive and kicking, and in a very visible way. This sort of thinking, for example, lies behind the insistence that the Stability Pact backing the euro be relaxed to allow governments to run deficits of more than three per cent.
In economics, Prof. Keynes is a giant, even though adherents to the monetarist school have their reservations; they consider him to be the man who provided profligate politicians in government with an economic theory to justify their excesses with other people's money. But he was definitely influential and, because of his dominance, for a long time everybody thought that, while advances in technology provided the basic long-term drive of the economy, it was demand which gave rise to the business cycle, the intermediate boom and bust of the economy.
Prof. Kydland and Prof. Prescott modified this thinking structure and attempted to demonstrate that what happens on the supply side - that is, what happens on the production side of the economy - matters a lot and is important not just for the long-term development of economies but also for the (shorter) business cycle.
They refocused the thinking of economists so that they no longer pinned the causes of the business cycle on demand but started looking at supply as well, such as the price of oil and increases in productivity brought about by technological developments, including, in the current super-cycle, computerisation.
The first area cited is perhaps of more interest. Prof. Kydland and Prof. Prescott here deal with economic policy-making and observe that for someone in authority, such as the government, to have credibility it must also be consistent. The loss of credibility, which results if policies are not consistent across time - that is, if today you say or promise one thing and tomorrow you do another - can be very damaging to society because economic operators (all of us) adapt their behaviour accordingly.
The example most often given is that of trying to control inflation, but there are many others, such as limiting the government budget deficit. For example, since inflation is destabilising but gives a sense of well-being, a government which wants to optimise economic growth declares that it intends to control the amount of money created in order to limit inflation. This well-meaning government, when it comes to implement this policy, faces high unemployment and is forced to back down from the intended policy and give in to inflation in order to try to reduce unemployment.
Another government states that it intends to reduce the deficit, which means that it has to raise revenue or at least keep it stable and reduce spending. Even though that is its true intention, it finds cost-cutting to be hugely unpopular and gives in. It loses some of its credibility and people will not behave according to the intention but according to the facts as they unravel.
According to Prof. Kydland and Prof. Prescott this is a common situation and is not due to the lack of good intentions but often results from the very same behaviour of economic participants which place restrictions on policy decisions. This restriction leads to a lower welfare than if economic policies are time consistent and governments enjoyed credibility.
Consistency and authority, of course, feed on each other. The implications of policy on different parties in the economy, and these parties' likely reactions to the policy, have to be studied before the policies are announced. Prof. Kydland and Prof. Prescott believe that, in order for a policy or a sequence of policies to avoid the danger of time inconsistency, they must incorporate within them incentives for their execution.
For example, in Malta, the policy to remove exchange controls was planned, announced and executed seamlessly because each stage carried its own incentive on operators and, overall, was seen as tied to EU membership, which was generally viewed positively. There were some inconsistencies in applying the final withholding tax regime* and that is why it is so important that we defend our tax imputation system in the case of companies and shareholders.
Prof. Kydland and Prof. Prescott's studies, among other things, led to the policy of appointing independent central bankers.
Central banks have been made independent in various countries and the experience has been mixed. They did achieve a measure of success in being able to follow their set objectives somewhat removed from the government but, in general, at least in financial operators' minds, complete independence has so far eluded them; they seem to be at their boldest when not up for reappointment and most docile when they are.
Each country, indeed each decision maker, from parent to Federal Reserve Governor, has his or her own record of consistency and inconsistency. Prof. Kydland and Prof. Prescott are important because they explained the universal significance of the restrictions placed on economic policies and their effects, including forcing policies to be time inconsistent, and the importance for credibility of being consistent.
* See my Market View articles of February 5, 1996 and April 22, 1996, on this matter. Around one in every 10 Market View articles have been selected and thematically compiled in a book Investment and Finance - A Common Sense Approach, published by Progress Press this month. The April article appears there.
Paul V. Azzopardi is managing director of Azzopardi Investment Management Limited (www.azzopardi.com) which is licensed by the MFSA to provide investment services, including stockbroking. This article is only meant to provide information, which the writer believes to be accurate at the time of writing, and is not intended to give investment advice and its contents should not be construed as such. The value of securities, and the currencies in which they are denominated, may go down as well as up. Readers are requested to seek professional financial advice tailored to their own personal circumstances.