25 Feb 2023
Edward Prescott, co-recipient with Finn Kydland of the 2004 Nobel Memorial Prize in Economic Sciences, passed away in November 2022. This column, written by a long-time friend and co-author, outlines his many research contributions, including being one of the scholars that laid the foundation of the rational expectations revolution in dynamic macroeconomics. He and Kydland were the architects of real business cycle theory and the literature on time inconsistency, which has reshaped our thinking about the credibility of government commitments and had a profound impact on policymaking, particularly monetary policy.
On 6 November 2022, the economics profession lost one of its most creative and eclectic scholars, Edward C Prescott. To paraphrase his fellow Nobel laureate Robert Lucas, watching Ed Prescott doing economics was like watching a trapeze artist on a high wire: he took our breaths away with amazing feats of economic wizardry. 1
I was privileged to have a ringside seat starting in 1974. Our association evolved over the years from his role as a mentor to that of a co-author and colleague who was unfailingly generous with his time, with his ideas and with his friendship.
Ed was among a handful of scholars that laid the foundation of the rational expectations revolution in dynamic macroeconomics. He and Finn Kydland are considered the architects of real business cycle (RBC) theory and the literature on time inconsistency. For this research, they were awarded the 2004 Nobel Memorial Prize in Economic Sciences. As the Nobel citation put it, Prescott and Kydland’s work “not only transformed economic research but has also profoundly influenced the practice of economic policy in general, and monetary policy in particular”.
Although Ed was most closely associated with the work cited by the Nobel committee, his research spanned a wide spectrum of fields, including economic development, labour markets, industrial organisation, general equilibrium theory, asset pricing and econometrics. He also made significant contributions to methodology, having pioneered many of the contemporary tools and techniques in macroeconomics, most notably model calibration.
Ed was born on Boxing Day 1940 in Glens Falls, New York. He received a bachelor’s degree from Swarthmore, majoring in mathematics, and an MS in Operations Research from Case Western before moving to the Graduate School of Industrial Administration (GSIA) at Carnegie Mellon for his doctorate in economics and statistics, which he completed in 1967.
Ed joined Carnegie at a time when the multidisciplinary GSIA was a happening place. The ‘Carnegie School’ was in its heyday. Ed flourished in this challenging environment, writing his dissertation in statistical decision theory titled “Adaptive Decision Rules for Macroeconomic Planning”.
His foray into dynamic economic theory, which characterised much of his later work, began with his collaboration with Robert Lucas on “Investment Under Uncertainty” (Lucas and Prescott 1971). As Ed was to remark later, “…with this collaboration I became a Bob Lucas student and an economist … Bob Lucas is the most important person in my development as an economist”.
In 1971, Ed returned to Carnegie as a faculty member and continued his collaboration with Lucas (Lucas and Prescott 1974). He had also been working on using control theory to formulate and evaluate policy rules (Prescott 1972). But once he became aware of the ‘Lucas critique’, he realised this was futile.
This led to his first collaboration with Finn Kydland, then a graduate student at GSIA. To their surprise, they found that the optimal policy had the property that economic agents who follow it for a while inevitably realise there is a better alternative than pursuing the original policy. But if economic agents cannot commit to the policy, the ex-ante optimal policy is not feasible. In other words, the optimal policy was time inconsistent.
Their seminal paper (Kydland and Prescott 1977), which is arguably their most influential, reshaped our thinking about the credibility of government commitments. As a consequence of this research, many central banks worldwide have committed themselves to a policy of seeking low inflation. The United States, for example, has an implicit policy of pursuing low inflation, and, since the early 1990s, several countries, including New Zealand and the UK, have instituted an explicit policy of inflation targeting.
I first met Ed in the winter of 1974 in a course that he jointly taught with Howard Rosenthal: “Industry Structure, Imperfect Competition, and Organization Behavior”. The course had the distinction that it was ‘i.i.d.’ – both intra and inter-lecture! Ed more than made up for this idiosyncrasy by meeting us individually – in a setting where he was more comfortable, his office. This gave me the opportunity to get to know him and gain familiarity with ‘Ed speak’.
Ed often remarked that macro aggregates (consumption, investment and output) were not predicated on the actions of a central planner but arose from interactions among economic agents in competitive markets. He suggested that I try to decentralise the stochastic growth model. Easier said than done!
After a number of false starts and dead ends, we produced a draft of our first paper, later published as Prescott and Mehra (1980). In this paper, we show that the allocations in the neoclassical growth model can be viewed as the outcome of a competitive equilibrium, where firms maximise profits and households maximise utility. Moreover, the competitive allocations are Pareto optimal. The techniques developed in this paper were subsequently used by Ed in his seminal paper with Kydland (Kydland and Prescott 1982).
Having succeeded in decentralising the growth model, we naturally wanted to see how it performed when confronted with financial data. We started working on our second collaboration in 1979. Given the success of the neoclassical growth model and its ability to offer well-defined proxies for all the major data macro aggregates – consumption, investment and output – we expected the decentralised counterpart to pass with flying colours.
What we found was that the equity premium (the difference between the return on equity and the risk-free rate) implied by the model was an order of magnitude less than what was observed in the US stock market.
This finding was both a surprise and a disappointment, and it took us a while to accept our result. The profession, too, was sceptical, perhaps because our results challenged the neoclassical model. Much of our economic intuition is based on the same class of models that fall short so dramatically when confronted with financial data. It took us six years to convince the sceptics and for our paper to be published (Mehra and Prescott 1985).
Ed’s second major collaboration with Finn Kydland started after Finn returned to Carnegie in 1978 as a faculty member. Their paper, “Time to Build and Aggregate Fluctuations”, defined modern business cycle theory (Kydland and Prescott 1982). There were many aspects to this accomplishment, and it is worth detailing them individually.
The first was to provide a statistical description of the business cycle by characterising it as deviations from trend by exploring the relative standard deviations of the principal macro aggregates as well as their correlations with output. This portrayal of the business cycle was especially informative of labour market regularities and has remained the principal characterisation to this day.
The theoretical contributions to the underpinnings of the ‘Time to Build’ model were equally revolutionary. Although the underlying structure of the model is a variant of the neoclassical stochastic growth model, the equilibrium stochastic process was computed using recursive techniques developed in our joint work (Prescott and Mehra 1980).
A third innovation was the introduction of the idea of calibrating business cycle models – that is, choosing parameters of the model and its numerical approximations that had a foundation in well-conceived microeconomic studies. To do otherwise would be inconsistent with viewing the macroeconomy as the aggregation of many individual decisions.
Kydland and Prescott were able to quantify the extent to which business cycle fluctuations are the outcome of an optimal response of the economy to policy changes that affect its productivity. This was in sharp contrast to the then-prevailing wisdom that business cycle fluctuations were the result of monetary shocks. The theory has had remarkable successes when confronted with empirical data: it broadly replicates the essential features of the business cycle and plays a central role in modern dynamic macroeconomics.
While at Carnegie, Ed also collaborated with Robert Townsend on two seminal papers (Prescott and Townsend 1984a, 1984b). These papers established that a competitive market in contracts can have efficient outcomes. They unify two seemingly unconnected fields: contract theory and general equilibrium theory.
While contract theory takes into account the information constraints of moral hazard, unobserved states and other obstacles to trade, it was viewed as a partial equilibrium discipline, often with one of the parties to a contract being able to extract a surplus. It was thought that competitive markets with private information would fail.
By judiciously expanding the commodity space of general equilibrium theory to include the incentive constraints of contracts, letting contracts and participation in constraints be endogenous, and allowing free entry into intermediation, Prescott and Townsend were able to show that standard general equilibrium welfare theorems apply in this environment with the distribution of gains to trade determined by wealth.
Ed Prescott believed that a crucial tool in a macroeconomist’s toolkit was the neoclassical growth model. In his later research, he adapted this model to answer questions beyond the traditional ones in business cycle theory and asset pricing.
One area of particular interest to Prescott was why some countries are so poor: ‘why isn’t the whole world rich?’ In Parente and Prescott (1994), he argued that per capita income differences were related to constraints that poorer countries impose on firms’ choice of technology relative to rich countries. In this paper, they show that modest governmental barriers to technology adoption can indeed explain the observed cross-country pattern of per capita income differences. The paper is important to the literature not only for deriving a mapping between an economy’s policies and its total factor productivity growth but also for demonstrating the role of intangible capital in production.
As Prescott quickly realised, the next question was how these barriers arose and why did they persist? Prescott and Parente (1999) show that monopoly rights over the provision of labour inputs had strong negative effects on total factor productivity and could be a powerful disincentive to new technology adoption.
In a subsequent paper with Ellen McGrattan (McGrattan and Prescott 2009), Prescott extended the growth model to include firm-specific technology capital and argued that large gains to the per capita income of poor countries can arise by exploiting the technology capital of more advanced countries through foreign direct investment (FDI).
While we think of Edward Prescott as a supreme theorist, he was also fascinated by data: “some people are afraid of numbers; I like numbers”. His seminal insight in this context was to recognise that the standard NIPA (national income and product accounts) methods failed to account for investment in intangible capital (these expenditures were being treated as generic expenses). As a result, estimates of real output, real capital stock and labour productivity are all biased downward.
In a number of papers with McGrattan, Prescott pursued the consequences of this discrepancy, first by undertaking a full revision of the national accounts to make them more closely aligned with concepts basic to the neoclassical growth model. Incorporating an alternative production technology for the creation of intangible technological capital was the next theoretical starting point. Other papers explored various implications of recognising the importance of intangible capital.
In an important paper, McGrattan and Prescott (2005) address the value of the stock market and its supposed overvaluation at the time. By properly accounting for intangible technology capital (inferring its value and hypothesising that intangible and tangible must pay the same rate of return), they showed overvaluation was not the case.
In McGrattan and Prescott (2010), the authors explored the extent to which the proper incorporation of intangible investment of multinational firms can explain over 60% of the discrepancy between US firms’ return on their foreign investments and foreign firms’ investments in the US, previously estimated by the Bureau of Economic Analysis to be roughly 6%.
In Holmes et al. (2015), Prescott and his co-authors use the same concepts to estimate the benefits that China has received from its quid-pro-quo investment policy, where foreign firms must convey FDI technology transfer to their partners in China in exchange for market access. They concluded that while the policy had been highly beneficial to China, its advantage to the US was negative. As Prescott frequently argued, a theory without measurement could be highly misleading.
No discussion about Ed’s contribution would be complete without acknowledging his gift to the profession in the form of his students. Prescott supervised over 50 dissertations, and many of his students have distinguished themselves as leaders in their fields. Ed was extremely proud of his students, spending countless hours with them and making each one feel special. His in-depth mentoring endowed them with competence and confidence, an essential concomitant of a successful research career. They, in turn, reciprocated with admiration and affection.
The famous mathematician Mark Kac once distinguished between two kinds of geniuses: the ‘ordinary’ and the ‘magicians’. An ordinary genius is a fellow you and I would be just as good as if we were only many times better. It is different with magicians. The working of their minds is mysterious and profound, and even after we understand what they have done, the creative process by which they have done it is impossible to emulate. The last 50-odd years of collaborating with him have convinced me that Ed Prescott was truly a magician.
Author’s note: I would like to thank Costas Azariadis, VV Chari, Krishna Doraiswamy, Ellen McGrattan, Chaitanya Mehra, Stephen Parente, Rob Townsend, Sunil Wahal, and especially John Donaldson for their helpful comments.
Holmes, T J, E R McGrattan and E C Prescott (2015), “Quid Pro Quo: Technology Capital Transfers for Market Access in China”, Review of Economic Studies 82(3): 1154-93.
Kydland, F E, and E C Prescott (1977), “Rules Rather Than Discretion: The Inconsistency of Optimal Plans”, Journal of Political Economy 85(3): 473-91.
Kydland, F E, and E C Prescott (1982), “Time to Build and Aggregate Fluctuations”, Econometrica 50(6): 1345-70.
Lucas, R E, and E C Prescott (1971), “Investment Under Uncertainty”, Econometrica 39(5): 659-81.
Lucas, R E, and E C Prescott (1974), “Equilibrium search and unemployment“, Journal of Economic Theory 7(2): 188-209.
McGrattan, E R, and E C Prescott (2005), “Taxes, Regulations, and the Value of U.S. and U.K. Corporations”, Review of Economic Studies 72(3): 767-96.
McGrattan, E R, and E C Prescott (2009), “Openness, Technology Capital, and Development”, Journal of Economic Theory 144: 2454-76.
McGrattan, E R, and E C Prescott (2010), “Unmeasured Investment and the Puzzling US Boom in the 1990s”, American Economic Journal: Macroeconomics 2(4): 88-123.
Mehra, R, and E C Prescott (1985), “The equity premium: A puzzle”, Journal of Monetary Economics 15(2): 145-61.
Parente, S L, and E C Prescott (1994), “Barriers to Technology Adoption and Development”, Journal of Political Economy 102(2): 298-321.
Prescott, E C (1972), “The Multi-Period Control Problem Under Uncertainty”, Econometrica 40(6): 1043-58.
Prescott, E C (2002), “Prosperity and Depression”, American Economic Review 92(2): 1-15.
Prescott, E C, and R Mehra (1980), “Recursive Competitive Equilibrium: The Case of Homogeneous Households”, Econometrica 48(6): 1365-79.
Prescott, E C, and S L Parente (1999), “Monopoly Rights: A Barrier to Riches”, American Economic Review 89(5): 1216-33.
Prescott, E C, and R M Townsend (1984), “General Competitive Analysis in an Economy with Private Information”, International Economic Review 25(1): 1-20.
Prescott, E C, and R M Townsend (1984), “Pareto Optima and Competitive Equilibria with Adverse Selection and Moral Hazard”, Econometrica 52(1): 21-45.
- VV Chari’s notes from Lucas’s introduction to Prescott’s Ely Lecture at the American Economic Association annual meetings (Prescott 2002).