François Quesnay was the leading figure of the Physiocrats, generally considered to be the first school of economic thinking. The name “Physiocrat” derives from the Greek words phýsis, meaning “nature,” and kràtos, meaning “power.” The Physiocrats believed that an economy’s power derived from its agricultural sector. They wanted the government of Louis XV, who ruled France from 1715 to 1774, to deregulate and reduce taxes on French agriculture so that poor France could emulate wealthier Britain, which had a relatively laissez-faire policy. Indeed, it was Quesnay who coined the term “laissez-faire, laissez-passer.” Quesnay himself did not publish until the age of sixty. His first work appeared only as encyclopedia articles in 1756 and 1757. In his Tableau économique, he detailed his famous zigzag diagram, a circular flow diagram of the economy that showed who produced what and who spent what, in an attempt to understand and explain the causes of growth. Tableau defined three classes: landowners, farmers, and others—called “sterile” classes—who consumed everything they produced and left no surplus for the next period. Quesnay believed that only the agricultural sector could produce a surplus that could then be used to produce more the next year—and therefore help growth. Industry and manufacturing, thought Quesnay, were sterile. Interestingly, though, he did not reach this conclusion by consulting his table. Instead, Quesnay constructed the table to fit his belief. Indeed, he had to make his table inconsistent in order to fit his assumption that industry provided no surplus. Although Quesnay was wrong about the sterility of the manufacturing sector, he was right in ascribing France’s poverty to mercantilism, which he called Colbertisme (after Louis XV’s finance minister, Jean-Baptiste Colbert). The French government had protected French manufacturers from foreign competition, thus raising the cost of machinery for farmers, and had also sold to wealthy citizens the power to tax farmers. These citizens had then used this power to the limit. Quesnay advocated reforming these laws by consolidating and reducing taxes, getting rid of tolls and other regulations that prevented trade within France, and generally freeing the economy from the government’s stifling controls. These reforms were much more sensible than his theorizing about the sterility of industry. As Mark Blaug writes, “It was only the effort to provide these reforms with a watertight theoretical argument that produced some of the forced reasoning and slightly absurd conclusions that invited ridicule even from contemporaries.”1 Moreover, Quesnay’s work paved the way for classical economics—in particular for Adam Smith, who latched on to Physiocratic notions of free trade and the preeminence of the agricultural sector. That Quesnay had such a seminal influence on economics is all the more surprising in light of the fact that he served under Louis XV in Versailles not as an economist, but as a medical doctor. Selected Works   1759. Tableau économique. 3d ed. Reprint. Edited by M. Kuczynski and R. Meek. London: Macmillan, 1972.   Footnotes 1. Mark Blaug, Great Economists before Keynes (Atlantic Highlands, N.J.: Humanities Press International, 1986), p. 196.   (0 COMMENTS)

  Ludwig von Mises was one of the last members of the original austrian school of economics. He earned his doctorate in law and economics from the University of Vienna in 1906. One of his best works, The Theory of Money and Credit, was published in 1912 and was used as a money and banking textbook for the next two decades. In it Mises extended Austrian marginal utility theory to money, which, noted Mises, is demanded for its usefulness in purchasing other goods rather than for its own sake. In that same book Mises also argued that business cycles are caused by the uncontrolled expansion of bank credit. In 1926 Mises founded the Austrian Institute for Business Cycle Research. His most influential student, Friedrich Hayek, later developed Mises’s business cycle theories. Another of Mises’s notable contributions is his claim that socialism must fail economically. In a 1920 article, Mises argued that a socialist government could not make the economic calculations required to organize a complex economy efficiently. Although socialist economists Oskar Lange and Abba Lerner disagreed with him, modern economists agree that Mises’s argument, combined with Hayek’s elaboration of it, is correct (see socialism). Mises believed that economic truths are derived from self-evident axioms and cannot be empirically tested. He laid out his view in his magnum opus, Human Action, and in other publications, although he failed to persuade many economists outside the Austrian school. Mises was also a strong proponent of laissez-faire; he advocated that the government not intervene anywhere in the economy. Interestingly, though, even Mises made some striking exceptions to this view. For example, he believed that military conscription could be justified in wartime. From 1913 to 1934 Mises was an unpaid professor at the University of Vienna while working as an economist for the Vienna Chamber of Commerce, in which capacity he served as the principal economic adviser to the Austrian government. To avoid the Nazi influence in his Austrian homeland, in 1934 Mises left for Geneva, where he was a professor at the Graduate Institute of International Studies until he emigrated to New York City in 1940. He was a visiting professor at New York University from 1945 until he retired in 1969. Mises’s ideas—on economic reasoning and on economic policy—were out of fashion during the Keynesian revolution that took over American economic thinking from the mid-1930s to the 1960s. Mises’s upset at the Keynesian revolution and at Hitler’s earlier destruction of his homeland made Mises bitter from the late 1940s on. The contrast between his early view of himself as a mainstream member of his profession and his later view of himself as an outcast shows up starkly in The Theory of Money and Credit. The first section, written in 1912, is calmly argued; the last section, added in the 1940s, is strident. Mises had a strong influence on young people. The resurgent Austrian school in the United States owes itself in no small part to Mises’s persistence. Selected Works   1912. The Theory of Money and Credit. 3d English ed. Indianapolis: Liberty Classics, 1981. Available online at: http://www.econlib.org/library/Mises/msT.html 1920. “Economic Calculation in the Socialist Commonwealth.” Reprinted in Collectivist Economic Planning: Critical Studies on the Possibilities of Socialism. Edited by Friedrich Hayek. London: Routledge and Sons, 1935. 1921. The sections entitled “Finance and Banking” in two articles, “Austrian Empire” and “Republic of Austria,” in the 12th edition of the Encyclopaedia Britannica. Available online at: http://www.econlib.org/library/Mises/msEnc.html 1922. Socialism: An Economic and Sociological Analysis. 3d English ed. Indianapolis: Liberty Fund, 1981. Available online at: http://www.econlib.org/library/Mises/msS.html 1944. Omnipotent Government: The Rise of the Total State and Total War. Reprint. Springs Mill, Penn.: Libertarian Press, 1985. 1949. Human Action: A Treatise on Economics. 3d ed. Chicago: Regnery. 1966. 1996. Human Action: A Treatise on Economics. 4th rev. ed. Irvington-on-Hudson, N.Y.: Foundation for Economic Education. Available online at: http://www.econlib.org/library/Mises/HmA/msHmA.html   (0 COMMENTS)

  In 1996 James Mirrlees and william vickrey were awarded the Nobel Prize in economics “for their fundamental contributions to the economic theory of incentives under asymmetric information.” Mirrlees’s main contribution was some highly complex mathematics that allowed him to solve a problem in taxation that William Vickrey had posed but had not been able to answer. Many economists, including Mirrlees, want to use the tax system to achieve a higher degree of equality than would otherwise obtain. This means taking a substantial amount of the additional income of high-income people, which would imply high marginal tax rates on them. But when the government imposes such high marginal tax rates on the highest-income people, it reduces the incentive of the most productive people to be productive. There is, in short, a trade-off between equality and efficiency. Economists have long wanted to figure out the optimum, but until Mirrlees’s work no one had been able to solve it. Mirrlees started with no presumption against high marginal tax rates. Indeed, he has been an adviser to Britain’s Labour Party, which for decades imposed marginal tax rates in excess of 80 percent. But Mirrlees found that the top marginal tax rate should be only about 20 percent; and moreover, it should be about the same 20 percent for everyone. In short, Mirrlees’s work justified what is now known as a “flat tax,” more appropriately called a “flat tax rate.” Mirrlees wrote, “I must confess that I had expected the rigourous analysis of income taxation in the utilitarian manner to provide arguments for high tax rates. It has not done so.”1 Indeed. Mirrlees also proved that the marginal tax rate on the highest-income person should be zero. This is the opposite of the way most noneconomists and most politicians think: marginal tax rates are typically the highest on the highest-income people. Mirrlees’s reasoning is as follows. Imagine that the top tax rate is, say, 40 percent and that the top-earning person makes $500 million in a year before tax. If the government reduced the marginal tax rate to zero for all income over $500 million, it would not lose any revenue because no one was earning more than $500 million. But the individual currently earning $500 million might, because of the increased incentive to earn, decide to work more. He would be better off because he voluntarily chose to do something he did not do before, and the government would be no worse off. The net result is that society, which includes this individual, would be better off. Mirrlees’s work on consumption taxes produced another important finding. Working with American economist Peter Diamond, Mirrlees found that small economies should not impose tariffs on foreign trade and that taxation should be on consumption, not production. Mirrlees also did highly theoretical work on another incentive problem: “moral hazard.” As is well known to those who study insurance, insurance coverage gives the beneficiary an incentive to take more risks than would be optimal. This is called “moral hazard.” Mirrlees’s insight, based on a complex mathematical model, is that the problem can be solved with an optimal combination of carrots and sticks. Insurance payments are essentially a carrot. But “sticks” could be designed also, so that an insured person who takes risks pays a penalty for doing so. With this combination of carrots and sticks, the insured person acts almost as if he is uninsured, and the insurer acts almost as if he were the insured. Mirrlees has a refreshing, understated sense of humor. Of his early years in university Mirrlees wrote: “It was regarded as morally dangerous to take philosophy at the beginning of one’s university course.” Reminiscing in 1996 on the advice one of his Cambridge teachers gave him to read Keynes’s 1936 classic, The General Theory of Employment, Interest and Money, Mirrlees commented, “That may not have been the best advice, but it did no great harm, and one day I hope to finish it.” Born in Scotland, Mirrlees earned his M.A. in mathematics and natural philosophy from Edinburgh University in 1957 and his Ph.D. in economics from Cambridge University in 1963. He spent his early career at Cambridge, was an economics professor at the University of Oxford from 1968 to 1995, and returned to Cambridge in 1995 as an economics professor. Selected Works   1971. “An Exploration in the Theory of Optimum Income Taxation.” Review of Economic Studies 38: 175–208. 1971 (with Peter A. Diamond). “Optimal Taxation and Public Production I: Production Efficiency, II: Tax Rules.” American Economic Review 61: 8–27, 261–278. 1976. “The Optimal Structure of Incentives and Authority Within an Organization.” Bell Journal of Economics and Management Science 7: 105–131. 1976. “Optimal Tax Theory: A Synthesis.” Journal of Public Economics 6: 327–358.   Footnotes 1. Mirrlees 1971, p. 207.   (0 COMMENTS)

In 1979, British citizen W. Arthur Lewis was awarded the Nobel Prize, along with theodore schultz, for “pioneering research into economic development … with particular consideration of the problems of developing countries.” One of Lewis’s major contributions to economics is a 1954 article that discusses his concept of a “dual economy” in a poor country. According to Lewis a poor country’s economy can be thought of as containing two sectors, a small “capitalist” sector and a very large “traditional” (agricultural) sector. Employers in the capitalist sector hire people to make money. Employers in the traditional sector, on the other hand, are not profit maximizing and, therefore, hire too many people so that their productivity is very low. (The immediate question, of course, is why employers in the traditional sector would do this, and economists still debate Lewis’s reasons for thinking this.) Lewis argued on this basis that the way to spur development in poor countries is to shift labor into manufacturing, where it is more productive. The capitalists save out of their profits and use this saving to expand, which then adds to growth. Lewis assumed that workers in agriculture save nothing, so that the only source of saving is the capitalists in manufacturing. Lewis used his model to explain the pattern of growth in countries in general. This is how he explained the inverted-U-shaped growth according to a country’s per capita income. For very poor countries like Bangladesh, growth is slow because the manufacturing sector is small or nonexistent, and there is no large source of savings. For middle-income countries like Korea and Taiwan, growth is high because the manufacturing sector is growing and pulling labor out of agriculture, where it is underemployed. For high-income countries with a large manufacturing sector, like the United States, growth is slower because the gains from diverting labor out of agriculture are almost all exploited. In the same 1954 article Lewis made a separate argument for poor countries engaged in trade, maintaining that poor countries would capture little or no benefit from increasing their exports. Instead, he claimed, they would confer benefits on consumers in the countries that import their exports. Take his example in which the richer countries produce steel (shorthand for manufactured goods) and food, and the poorer countries produce coffee (shorthand for exports of poor countries) and food. Assume that before exports are increased, ten pounds of coffee trade for one ton of steel. Now, because producers in the poor countries have a low opportunity cost of increasing exports of coffee (because the food that they could have produced is worth little), they will increase exports. But doing so will drive down the price of coffee. Say the exchange rate falls to twenty pounds of coffee per ton of steel. This is a good deal for coffee buyers, but not for coffee producers. In essence, Lewis was arguing that poorer countries had latent monopoly power in their exports that they were failing to exploit. These countries would do better, he argued, to divert their production into food and away from exports. Lewis himself came from a poor British colony, Saint Lucia in the West Indies. He entered the London School of Economics on a scholarship at age eighteen. “I wanted to be an engineer,” Lewis later said, “but neither the colonial government nor the sugar plantations would hire a black engineer.” So he decided to study economics. He earned his Ph.D. from the London School of Economics in 1940. He began working on problems of the world economy at the suggestion of friedrich hayek, then chairman of the LSE’s economics department. After World War II, when many former colonies became independent, Lewis began his study of economic development. Lewis had no sympathy for the view that poor countries should be run by dictators so that they could develop. Lewis was a lecturer at the University of London from 1938 to 1948, then Stanley Jevons Professor of Political Economy at the University of Manchester from 1948 to 1958. He was vice chancellor of the University of West Indies from 1959 to 1963 and a professor of political economy at Princeton University from 1963 until his death. Selected Works   1949. Economic Survey 1919–1939. London: Allen and Unwin. 1954. “Economic Development with Unlimited Supplies of Labour.” Manchester School 22 (May): 139–191. 1955. The Theory of Economic Growth. London: Allen and Unwin. 1965. Politics in West Africa. London: Allen and Unwin. 1980. “The Slowing Down of the Engine of Growth.” Nobel Lecture. Printed in American Economic Review 70, no. 4: 555–564.   (0 COMMENTS)

  Simon Kuznets is best known for his studies of national income and its components. Prior to World War I, measures of GNP were rough guesses, at best. No government agency collected data to compute GNP, and no private economic researcher did so systematically, either. Kuznets changed all that. With work that began in the 1930s and stretched over decades, Kuznets computed national income back to 1869. He broke it down by industry, by final product, and by use. He also measured the distribution of income between rich and poor. Although Kuznets was not the first economist to try this, his work was so comprehensive and meticulous that it set the standard in the field. His work was funded by the nonprofit National Bureau of Economic Research, which had been started in 1920. Kuznets later helped the U.S. Department of Commerce to standardize the measurement of GNP. In the late 1940s, however, he broke with the Commerce Department over its refusal to use GNP as a measure of economic well-being. He had wanted the department to measure the value of unpaid housework because this is an important component of production. The department refused, and still does. Kuznets’s development of measures of savings, consumption, and investment came along just as Keynes’s ideas about how national income is determined created a demand for such measures. Thus, Kuznets helped advance the Keynesian revolution. Kuznets’s measures also helped advance the study of econometrics established by ragnar frisch and jan tinbergen. Kuznets approached his work with a strict adherence to fact and a desire to understand economic phenomena through quantitative measurement. He had started early in his native Russia: he was head of a statistical office in the Ukraine under the Bolsheviks before moving to the United States at age twenty-one. Many economists believe that Kuznets received the 1971 Nobel Prize for his measurement in national income accounting, and certainly that was enough to merit the prize. But in fact, the prize was awarded for his empirical work on economic growth. In this work Kuznets identified a new economic era—which he called “modern economic growth”—that began in northwestern Europe in the last half of the eighteenth century. The growth spread south and east and by the end of the nineteenth century had reached Russia and Japan. In this era, per capita income rose by about 15 percent or more each decade, something that had not happened in earlier centuries. One of Kuznets’s more startling findings concerns the effect of economic growth on income distribution. In poor countries, he found, economic growth increased the income disparity between rich and poor people. In wealthier countries, economic growth narrowed the difference. In addition, Kuznets analyzed and quantified the cyclical nature of production and prices in spans of fifteen to twenty years. Such trade cycles, while disputed, are often referred to as “Kuznets cycles.” Kuznets was a professor of economics at the University of Pennsylvania (1930–1954), Johns Hopkins University (1954–1960), and Harvard University (1960–1971). He was president of the American Economic Association in 1954. Selected Works   1934. National Income, 1929–1932. Senate document no. 124, 73d Congress, 2d session. 1937. National Income and Capital Formation, 1919–1935. New York: National Bureau of Economic Research. 1945 (with Milton Friedman). Income from Independent Professional Practice. New York: National Bureau of Economic Research. 1946 (assisted by Lillian Epstein and Elizabeth Jenks). National Product Since 1869. New York: National Bureau of Economic Research. 1953 (assisted by Elizabeth Jenks). Shares of Upper Income Groups in Income and Savings. New York: National Bureau of Economic Research. 1965. Economic Growth and Structure: Selected Essays. New York: Norton. 1966. Modern Economic Growth: Rate, Structure, and Spread. New Haven: Yale University Press. 1971. Economic Growth of Nations: Total Output and Production Structure. Cambridge: Belknap Press of Harvard University Press.   (0 COMMENTS)

Tjalling Koopmans shared the 1975 Nobel Prize with Leonid Kantorovich “for their contributions to the theory of optimum allocation of resources.” Koopmans, a native of the Netherlands, started in mathematics and physics, but in the 1930s switched to economics because it was “closer to real life.” In 1938 he succeeded Jan Tinbergen at the League of Nations in Geneva and then left in 1940 when Hitler invaded the Netherlands. In the United States, Koopmans became a statistician with the Combined Shipping Adjustment Board in Washington where he tried to solve the practical problem of how to reorganize shipping to minimize transportation costs. The problem was complex: the variables included thousands of merchant ships, millions of tons of cargo, and hundreds of ports. He solved it. The technique he developed to do so was called “activity analysis” and is now called linear programming. His first write-up of the analysis is in a 1942 memorandum. His techniques were very similar to those used by Kantorovich, whose work he discovered only much later. Koopmans was also like Kantorovich in generalizing his approach from one sector of the economy to the economy as a whole. Koopmans showed the conditions required for economy-wide efficiency in allocating resources. He also, again like Kantorovich, used his activity analysis techniques to derive efficient criteria for allocating between the present and the future. Koopmans was an economist with the Cowles Commission at the University of Chicago between 1944 and 1955, and then moved with the Cowles Commission to Yale University, where he became a professor of economics until he retired in 1981. Koopmans became an American citizen in 1946. He served as president of the American Economic Association in 1981. Selected Works   1942. “Exchange Ratios Between Cargoes on Various Routes (Non-refrigerating Dry Cargoes).” Memorandum for the Combined Shipping Adustment Board. 1942. Reprinted in Koopmans, Scientific Papers. Berlin: Springer, 1970. 1947. “Optimum Utilization of the Transportation System.” Proceedings of the International Statistical Conferences 5: 136–145. Reprinted in Supplement to Econometrica 17 (July 1949): 136–146. 1957. Three Essays on the State of Economic Science. New York: McGraw-Hill. 1970. Scientific Papers of Tjalling C. Koopmans. Berlin: Springer. Contains a bibliography through September 1969.   (0 COMMENTS)

  Carl Menger has the twin distinctions of being the founder of Austrian economics and a cofounder of the marginal utility revolution. Menger worked separately from William Jevons and Leon Walras and reached similar conclusions by a different method. Unlike Jevons, Menger did not believe that goods provide “utils,” or units of utility. Rather, he wrote, goods are valuable because they serve various uses whose importance differs. For example, the first pails of water are used to satisfy the most important uses, and successive pails are used for less and less important purposes. Menger used this insight to resolve the diamond-water paradox that had baffled Adam Smith (see marginalism). He also used it to refute the labor theory of value. Goods acquire their value, he showed, not because of the amount of labor used in producing them, but because of their ability to satisfy people’s wants. Indeed, Menger turned the labor theory of value on its head. If the value of goods is determined by the importance of the wants they satisfy, then the value of labor and other inputs of production (he called them “goods of a higher order”) derive from their ability to produce these goods. Mainstream economists still accept this theory, which they call the theory of “derived demand.” Menger used his “subjective theory of value” to arrive at one of the most powerful insights in economics: both sides gain from exchange. People will exchange something they value less for something they value more. Because both trading partners do this, both gain. This insight led him to see that middlemen are highly productive: they facilitate transactions that benefit those they buy from and those they sell to. Without the middlemen, these transactions either would not have taken place or would have been more costly. Although Adam Smith beat him to it in The Wealth of Nations (Book I, Chapter IV), Menger came up with an explanation of how money develops that is still accepted today. If people barter, he pointed out, then they can rarely get what they want in one or two transactions. If they have lamps and want chairs, for example, they will not necessarily be able to trade lamps for chairs but may instead have to make a few intermediate trades. This is a hassle. But people notice that the hassle is much less when they trade what they have for some good that is widely accepted, and then use this good to buy what they want. The good that is widely accepted eventually becomes money. Modern economists describe this function of money as “avoiding the need for the double coincidence of wants.” Indeed, the word “pecuniary” derives from the Latin pecus, meaning “cattle,” which in some societies served as money. Other societies have used cigarettes, cognac, salt, furs, or stones as money. As economies became more complex and wealthier, they began to use precious metals (gold, silver, and so on) as money. Menger extended his analysis to other institutions. He argued that language, for example, developed for the same reason money developed—to facilitate interactions between people. He called such developments “organic.” Neither language nor money was developed by government. The austrian school of economic thought first coalesced from Menger’s writings and those of two young disciples, Eugen von Böhm-Bawerk and Friedrich von Wieser. Later Austrian economists Ludwig von Mises and Friedrich Hayek used Menger’s insights as a starting point, Mises with his work on money and Hayek with his idea of “spontaneous order.” Carl Menger was born in Galicia, part of Austro-Hungary (now southern Poland), to a prosperous family. He had two brothers, Anton and Max. Both brothers were lawyers, and Anton was a legal philosopher and socialist historian. Menger’s son, Karl Menger, was a prominent mathematician who spent most of his professional life in the United States and died in 1985. Carl earned his doctorate in law from the University of Kraków in 1867. As a result of publishing his Principles of Economics in 1871, he was given a lectureship and then a professorship at the University of Vienna, which he held until 1903. In 1876 he took a post as tutor for Crown Prince Rudolf of Austria. In that capacity he traveled throughout Germany, France, Switzerland, and England. Selected Works Further Reading   1871. Principles of Economics. Translated by J. Dingwall and B. F. Hoselitz, with an introduction by Friedrich A. Hayek. New York: New York University Press, 1981. 1892. “On the Origin of Money.” Economic Journal 2 (June): 239–255.   “Mises Introduces the Austrian School,” http://mises.org/daily/3512 from Ludwig von Mises, Memoirs. Joseph T. Salerno, “Biography of Carl Menger: The Founder of the Austrian School (1840-1921),” http://mises.org/about/3239   (0 COMMENTS)

  James Meade, an Englishman, was corecipient of the Nobel Prize in 1977, along with Bertil Ohlin, for their “pathbreaking contribution to the theory of international trade and international capital movements.” Much of Meade’s work on international trade is in the two volumes of his Theory of International Economic Policy, which, writes Mark Blaug, “have become the bible of every trade economist.” The book’s first volume, The Balance of Payments, makes the point that for each of its policy objectives, the government requires a policy tool, a principle developed by Dutch economist Jan Tinbergen. Meade advocated using fiscal policy to achieve full employment and monetary policy to achieve the government’s target on balance of payments. The second volume, Trade and Welfare, examines conditions under which free trade makes a country better off and conditions under which it does not. Meade concluded that, contrary to previous beliefs, if a country was already protecting one of its markets from international competition, further protection of another market could be “second best.” That is, although the ideal would be to eliminate all trade barriers, if for some reason this was not feasible, then adding a carefully chosen dose of protectionism could improve the nation’s economic well-being. Like Milton Friedman in the United States, Meade wanted to use economics to help make the world a better place and believed that government regulation often harmed an economy. He also believed that government should take strong measures to promote equality of income. “I have my heart to the left and my brain to the right,” Meade said. Meade also helped prepare the British government’s set of national income accounts during World War II. Meade was a professor of commerce at the London School of Economics from 1947 to 1957 and then moved to Cambridge University, where he taught until he retired in 1974. Selected Works   1951. The Theory of International Economic Policy. Vol. 1: The Balance of Payments. Vol. 2: Trade and Welfare, with “Mathematical Supplements.” London: Oxford University Press. 1952. A Geometry of International Trade. London: Allen and Unwin. Reprint. New York: Augustus M. Kelley, 1969.   (0 COMMENTS)

  Finn Kydland, along with edward prescott, received the 2004 Nobel Prize in economic science “for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles.” Because Kyland and Prescott worked so closely, this biography deals with their work on time consistency and Prescott’s biography deals with their work on business cycles. Although the issue of time consistency might sound arcane, it is crucial for economic policy. In their classic 1977 article, Kydland and Prescott pointed out that even governments that care deeply about their citizens often have “time-consistency” problems. A government may decide, for example, in the interest of all its citizens not to subsidize people’s losses if they are flooded. The reason is that if people expect to be bailed out when flooded, they will locate in areas where it is inefficient for them to locate, because they are not bearing the whole cost of that location decision. So the government announces that it will not bail out people if their homes are damaged by floods. Then a flood comes, and the government decides that the optimal strategy is to bail people out: there is no danger of the bailout causing them to locate there because they already have. Here is the problem: people figure out that the government has this time-consistency problem—making a decision later that contradicts the earlier announced policy—and so do locate in the flood-prone area in the first place. Of course, people do not talk about the government in these terms, but they will try to estimate how likely it is that the government will cave in to political pressure and change its policy. If there is even some substantial likelihood, people’s decisions to live in the flood-prone area will be distorted by it. In short, unless they can make a binding commitment regarding future policies, even governments that care about their people will have a credibility problem. Kydland and Prescott modeled this problem mathematically and showed that it applies to many policy issues. For example, “time inconsistency” could explain why governments had trouble ending inflation. Although low or zero inflation is an optimal long-run policy, a government that announces a monetary policy to achieve it will be tempted to increase the growth rate of the money supply so as to reduce unemployment. But each year, government will find itself in that position and may never take the necessary painful short-run measures to end inflation. Kydland’s and Prescott’s answer to the problem of persistent high inflation was to make central banks follow rules that would prevent them from inflating. But many economists and most government officials want the central bank to have some flexibility to deal with unanticipated events. The solution: structure the incentives so that central banks will care about keeping inflation low, but will still have the power to deal with unanticipated events. Economist Kenneth Rogoff,1 building on Kydland’s and Prescott’s framework, showed that this optimal balance between credibility and flexibility could be achieved if monetary policy were delegated to an independent central bank and if the central bank were managed by someone more averse to inflation than the citizens in general. Interestingly, Alan Greenspan, an inflation “hawk,” became chairman of the Federal Reserve Bank just two years after Rogoff’s research. Also, reforms of central banks in New Zealand, Sweden, and the United Kingdom were based on academic economists’ research that drew on the Kydland-Prescott framework—and the result was a substantial decline in inflation in those three countries. Another example of the time-consistency problem is patents. Patents involve a trade-off between the short-term welfare loss from monopoly exploitation of a patent and the long-term welfare gain from the patent-induced incentive to innovate (see intellectual property). A government that does not credibly commit to enforcing patents will often violate the intellectual property rights of patentees. Many governments around the world are doing this with patents on drugs. Potential innovators, anticipating this, will innovate less. So a government that wants optimal innovation needs to figure out some way to lock itself in to protecting patents in the future. One final example is tax policy. The incentive to accumulate capital will depend on the anticipated tax rate on capital in the future. A government may commit to a low tax rate in order to encourage capital formation. But once people have invested in capital, governments will be tempted to raise the tax rate on capital because the capital is already “formed.” Again, though, many people will anticipate this and, unless the government is tied in to its commitments, will invest less in capital than otherwise. One can see the U.S. Constitution, along with an independent judiciary that enforces it, as a way of handling this credibility problem. Kydland is a citizen of Norway. He earned his B.S. from the Norwegian School of Economics and Business in 1968 and his Ph.D. from Carnegie Mellon University in 1973. He is currently a professor at the University of California at Santa Barbara and at Carnegie Mellon University. Selected Works   1977 (with Edward Prescott). “Rules Rather than Discretion: The Inconsistency of Optimal Plans.” Journal of Political Economy 85: 473–490. 1982 (with Edward Prescott). “Time to Build and Aggregate Fluctuations.” Econometrica 50: 1345–1371. 2002 (with Carlos E. J. M. Zarazaga). “Argentina’s Lost Decade.” Review of Economic Dynamics 5, no. 1: 152–165.   Footnotes 1. Kenneth Rogoff, “The Optimal Degree of Precommitment to an Intermediate Monetary Target,” Journal of International Economics 18 (1985): 1169–1190.   (0 COMMENTS)

  Polish economist Oskar Lange is best known for his contributions to the economics of socialism. His views on the feasibility of socialism changed back and forth throughout his life. While teaching at the University of Kraków in 1934, he outlined, with coauthor Marek Breit, a version of socialism in which the government owned all plants and each industry, called a public trust, was organized as a monopoly. Workers would have a large say in running each industry. Lange left Europe in 1935 to teach at the University of Michigan. In 1936 and 1937 he entered the debate with friedrich hayek about the feasibility of socialism. He presented “market socialism,” in which the government would own major industries and a central planning board (CPB) would set prices for those industries. The CPB would alter prices to reach equilibrium, raising them to get rid of shortages and lowering them to get rid of surpluses. Hayek pointed out that having government set prices to mimic competition, as Lange suggested, seemed inferior to having real competition. Whether in response to Hayek’s criticism or for other reasons, Lange modified his proposal, advocating that the government set prices only in industries with few firms. In 1943 Lange moved to the University of Chicago. That same year he advocated that the Polish government socialize key industries, but that farms, shops, and many other small and medium-sized industries remain in private hands. A large private sector, he wrote, was necessary to preserve “the kind of flexibility, pliability and adaptiveness that private initiative alone can achieve.” In 1945, Poland’s newly formed communist government appointed Lange ambassador to the United States, and in 1946 he became Poland’s delegate to the United Nations. When Stalinist orthodoxy was imposed in Poland in 1949, Lange was recalled to Poland and given a minor academic job. In 1953, with Poland still under Stalinist oppression, Lange reversed himself and wrote an article praising Stalin’s totalitarian economic control. In 1955, after the political oppression had lifted somewhat, Lange was made a professor at the University of Warsaw and chairman of the Polish State Economic Council. Selected Works   1936. “On the Economic Theory of Socialism, Part I.” Review of Economic Studies 4, no. 1: 53–71. 1937. “On the Economic Theory of Socialism, Part II.” Review of Economic Studies 4, no. 2: 123–142. 1942. “The Foundations of Welfare Economics.” Econometrica 10, nos. 3–4: 215–228. 1943. Working Principles of the Soviet Economy. New York: Russian Economic Institute.   (0 COMMENTS)