Economics Nobel: how this year’s winners helped to smooth the cycle of economic peaks and troughs

The Royal Swedish Academy of Sciences has awarded this year’s Nobel Prize in Economic Sciences to the American economists Robert E. Hall and Michael Woodford. The prize was awarded in recognition of their development of macroeconomic models that helped to reduce the length and depth of economic downturns.

According to the Academy, the economists’ work in macroeconomic modelling has given policymakers additional tools to smooth out the economic cycle. As well as reducing the severity of downturns, their work also helped to cool the potentially negative impacts of economic booms.

Economies are known to follow cycles of downturns and upturns – and economists have long sought to find ways to tame these. More than a century ago, British economist John Maynard Keynes developed an approach to managing the economy that came to be known as Keynesianism.

Before this, the classical “laissez-faire” approach dominated. According to this doctrine, in an economic downturn, markets would eventually clear and the economy would rebound. Any attempt by government to directly influence the economy would not work and could even make things worse.

Keynes disagreed with the classical view. He believed that economies could get locked into a downward spiral that would deepen recessions and lead to economic depression. Instead, he argued that governments could actively use the levers of monetary policy (adjusting interest rates) and fiscal policy (lowering taxes and government spending) to improve the health of the economy.

In the aftermath of the 1929 Wall Street crash, the US was in a deep economic depression. Franklin D. Roosevelt won a landslide presidential victory in 1932 and his “New Deal” approach to economic policy was similar to what Keynes advocated. The US economy recovered, and the Keynesian school would dominate policymaking in many advanced economies after the second world war.

But the oil crisis of the 1970s changed everything. The Keynesian approach was ineffective in dealing with low growth, spiralling inflation and high unemployment. Ronald Reagan and Margaret Thatcher won elections in the US and UK with promises of “smaller government” economic policy, including lower taxes, privatisation and deregulation. Keynesianism needed a rebuild.

Decisions of consumers and businesses

Hall and Woodford became part of the “New Keynesian” school that emerged in the 1980s. Their approach was to build models that looked at decisions made by millions of individuals and businesses rather than just considering macroeconomic variables like production, inflation, consumption and unemployment.

Hall, of Stanford University in California, is an expert in consumption theory. According to his “random walk hypothesis”, decisions made by households on whether to spend or save were directly influenced by their expectations about future income and economic conditions. In other words, they were not just based on their current financial conditions. As consumption makes up around 70% of GDP in advanced economies, these insights were important.

Woodford, of Columbia University in New York, is an expert in supply-side macroeconomics, specifically the role that expectations play in price-setting and inflation. In his 2003 book, Interest and Prices: Foundations of a Theory of Monetary Policy, he proved that a central bank could influence economic activity by managing the public’s expectations about what might happen to interest rates in future.

Up until the 1990s, central bank policymaking was secretive and could sometimes take markets by surprise. Hall and Woodford’s insights changed this. In the aftermath of the 2008 global financial crisis, the central banks of most major advanced economies adopted an approach known as “forward guidance”.

This policy saw central bank governors provide greater transparency about their monetary policy intentions. Forward guidance policy announcements provide a clear assessment of both the economic outlook and how this might affect inflation. They also set out how central bank policy could react to these assessments.

As with most policy approaches, forward guidance has both advocates and critics. Research from the European Central Bank shows that clear communication from central banks reduces short-term interest rate volatility. There is also some evidence that after the 2008 financial crisis, expectations that inflation would remain low helped to keep interest rates down. This probably encouraged spending and investment, which aided economic recovery.

But critics believe that forward guidance has no impact on long-term interest rates and say it is debatable if it has any impact on short-term rates. They also argue that setting expectations about interest rates can strip credibility from central banks. This could happen if economic policy needs to be altered to deal with sudden shocks, for example.

The conflicts in the Middle East and Ukraine are driving up energy prices and inflation expectations. The forward guidance from many central bankers is pointing to higher inflation and perhaps the need for higher interest rates.

Anyone coming off a fixed-rate mortgage might be sceptical of the idea that policy tools can lower short-term interest rate expectations. This is not to say that Hall and Woodford’s work has not been transformative. But economies are difficult beasts – and debates around central bank policymaking are sure to continue.

Conor O’Kane does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.