You have probably already heard that Edmund Phelps, McVickar Professor of Economics of Political Economy at Columbia University, has received the 2006 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel "for his analysis of intertemporal tradeoffs in macroconomic policy." The Wall Street Journal takes a stab (on page A2 in the print edition) at explaining what those words mean:
In the late 1960s, Mr. Phelps and University of Chicago economist Milton Friedman, who won a Nobel in 1976, challenged the conventional wisdom. They suggested that if inflation rose faster than expected, people and companies would adjust their expectations, prompting wages and prices to rise at the new, faster rate. As a result, economic stimulus aimed at reducing unemployment could keep pushing inflation higher and higher, as new price rises compounded on expected price rises...
To this day, central bankers such as Fed Chairman Ben Bernanke watch expectations closely in deciding what to do with interest rates...
Mr. Bernanke, in a textbook he co-wrote with fellow economist Andrew Abel while still a professor at Princeton, referred to Mr. Phelps's work as "one example of economic theorists predicting an important development in the economy that policy makers and the public didn't anticipate."
No argument there, but I am less sure about this:
The Nobel committee also cited Mr. Phelps's work establishing a "golden rule" of capital formation, which states that any given generation should save and invest a certain amount so that future generations will be able to enjoy a similar standard of living.
I added the emphasis on "should", because that is where, in retrospect, the lessons of Phelps' work need to be taken with some care. The following is from a 1989 paper written by Andy Abel, Greg Mankiw, Larry Summers, and Richard Zeckhauser:
In a celebrated article, Peter Diamond (1965) shows a competitive economy can reach a steady state in which there is unambiguously too much capital. In situations where the population growth exceeds the steady state marginal product of capital, or equivalently the economy is consistently investing more than it is earning in profit, the economy is said to be dynamically inefficient. In the terminology of Phelps (1961), the capital stock exceeds its Golden Rule level. A Pareto improvement can be achieved in a dynamically inefficient economy by allowing the current generation to devour a portion of the capital stock and the holding constant the consumption of all future generations.
There are a lot of economist words there, but the basic idea is this: If the economy is saving too much -- above the Golden Rule rate -- you can make current generations better off, without making future generations worse off, by implementing policies that reduce national saving. Because someone can be made better off without making another worse off, in the world of economics this is something you should do.
But things are different when the people in an economy are saving at rates lower than that prescribed by the Golden rule. What we know from the work of Diamond referenced by Abel et al is that there is no such free lunch when people are saving at rates below the Golden Rule. That is, there is no unambiguous improvement in long-run welfare because there are tradeoffs between the consumption of current and future generations. In this case, words like "should" apply to the world of value judgments -- and in that world, economists have no claim to special expertise.
Although for a different reason, Professor Phelps also warns about pushing the Golden Rule idea too far. Again from the WSJ article:
Mr. Phelps, however, said it is hard to know whether or not the U.S. is getting into trouble [by saving too little] because important pieces of information -- such as how productive the U.S. economy will be -- are lacking. "The question is not as simple as it might look," he said. "Maybe productivity will rise so rapidly as to dwarf the demographic overhang, so we won't understand why it was that we were ever worried about it when we get there."
An important idea -- and important to get it precisely right.