Since winning the Nobel Prize for economics in 2004, Finn Kydland’s schedule has been packed with world travel and public lectures. Yet the University of California, Santa Barbara professor says he still makes time to collaborate on research, with several projects in the pipeline. In his current work, Kydland says he’s in the process of writing about an experiment with a colleague at the Federal Reserve Bank of Dallas, revising a paper with two coauthors about what he calls "an interesting potential anomaly in international data," and finishing a joint paper about the housing sector.

During the recent Festival of Thinkers conference in Abu Dhabi, Kydland sat down with Arabic Knowledge at Wharton to discuss the world economy. He linked his Nobel-winning theory with current global economic realities, highlighting some of his concerns with fiscal policymaking; shared his perspective on emerging economies; and explained how academic training of up-and-coming economists could be refined.

An edited transcript of the conversation follows:

Arabic Knowledge at Wharton: What are the biggest challenges facing the global economy today as you observe the current landscape?

Finn Kydland: I think the biggest challenge is the lack of predictability of government policies. It has different facets. The theory with which I’m associated with is called the inconsistency of optimal government policy, or the time inconsistency, I should say. So what it says is even in the case of a benign government who’s trying to maximize welfare, the present value of its citizens’ welfare — imagine we can measure that — the resulting optimal plan is time-inconsistent, in the sense that there will always be this temptation to change in the absence of a commitment mechanism to make sure that it’s carried through over time. There will always be a temptation to change that plan, and if they continue to do so, theory suggests that that could be quite harmful to society. I never tried to push that as particularly relevant to the world until the last four or five years. And now it seems extremely relevant.

Arabic Knowledge at Wharton: What was it that struck you as relevant, that clicked together the theory and reality?

Kydland: Well, it kind of has this loose prediction that especially in the case of where the government can argue there’s an emergency, they will focus more on short-term issues rather than the long-run, even though most economists will agree that the long-run is much more important than the short-run. And I think one could associate much of what the U.S. government and European governments have done in the past few years, loosely with this theory. It’s not that surprising an outcome, and if it becomes obvious that the governments are not behaving very consistently over time, then it becomes harder to predict what they’re going to do, say one or two, or five years into the future. Many of the important decisions that drive private decisions that drive long-run growth, investment in new productive capacity, innovative activity — not just in better way of producing things but in production processes, new products and so on — entrepreneurial activity, they’re very forward-looking decisions, where if you become uncertain about the future or you worry that say the taxes on the returns from your activity will go up in the future, that could just mean that you’ve become much more reluctant to undertake such activity, or you postpone it until you gain greater confidence. And I think governments recently have lost some confidence among investors, and that could be harmful… It’s a challenge facing these forward-looking decision-makers to decide what can I expect from government in the next few years. It’s also a challenge for governments themselves to rebuild this credibility that would be beneficial for the longer-run.

Arabic Knowledge at Wharton: From your vantage as an informed observer, when you look at what the U.S. and Europe are doing in terms of their governmental policies, what’s your assessment, and are you concerned?

Kydland: I’m mainly concerned about fiscal policy. Monetary policy I think has been carried out, I really can’t complain about it and it’s not that important for the long-run anyway, at least under normal circumstances. I think it’s fiscal policy, tax policy, government spending and so on that are the key aspects of government policy that can play a role for real activity. And the buildup of government debts in many countries I think is a great concern, but because presumably at some point someone will have to pay for it, and the question is who? Will it be me, as an investor in future productive activities or an investor in entrepreneurial activity and so on? And if you think that there’s a chance, a good chance, that say the income on those returns, say capital income taxes will go up-just to pull numbers out of a hat-from 40 to 50 percent, that will make many projects that are otherwise would have been profitable will make them unprofitable. And so it would hamper investment activity, and that seems to be what has happened, in the United States at least. I have not looked at the data for Europe.

One of the things I do in my public lectures is I show a picture of real GDP per capita since 1947, which is pretty much when good data begin. If you take a constant growth rate trend through the data from ’47 through 2007-a constant growth rate trend works pretty well-I mean the picture looks at their ups and downs corresponding to the business cycles, but by and large…the data correspond well to a constant growth rate trend. And then after 2008, 2009, boom, you drop 10 or 12 percent below trend and that’s in large part because of investment activity has dropped. And I’ve done some model experiments myself with a coauthor from the Dallas Fed and this notion that suddenly, or around that time people were getting more concerned about the government debt and worried about possibly taxes going up in the future, if such an expectation became prevalent it would be consistent with the drop that we have seen and it’s also consistent with their recovery being very slow. So that would be a source concern.

Now it’s true that Bush introduced this temporary reduction in taxes that was due to expire January 1st 2011, this year, as it turns out it was postponed. At the last minute, they postponed the increase by two years, until January 1st, 2013, but two years…doesn’t make much of a difference for investment behavior, so the prediction would stand whether they expected it in 2011 or 2013, it still remains to be seen whether what’s going to happen by then. It’s something for investors to worry about. It’s a prediction of this time-inconsistency literature that that’s where they’re likely to look for sources of revenue and it’s also empirically what happened the last time the government debt showed such a buildup during World War II. After World War II, the debt was reduced dramatically starting in the 50s primarily by an increase in taxes on capital, physical human capital.

Arabic Knowledge at Wharton: Given where we are right now, do entrepreneurs still have a place at the table?

Kydland: They’re crucial. In any vibrant economy the entrepreneurs are, based on what I know, they are the key driving force for long-run growth. It’s true that large companies also experience some growth. But I believe studies show that the key to long-run growth are the smaller companies, the startups, the entrepreneurs- who are maybe struggling, may need financial support, ways of financing their activities-so they rely on a well-functioning financial system. If they become more reluctant, let’s say, to engage in that sort of activity that’s not good for the long run of the economy.

Arabic Knowledge at Wharton: Do you think that the problems or forces that created the recession, the global economic woes have been remedied?

Kydland: No, I don’t think so. And it goes back to what I said about the uncertainty about future government policy. There’s no more certainty now than there was two years ago, I don’t think, and until there becomes more certainty or more transparency in what they’re going to do for more than the next few months then I’m not very optimistic. I don’t think we have solved very much. And some time has elapsed since the big decline and so far the economy has been growing but at slow rates.

I should say by the way there is another reason that one could have become worried about the debt around 2008, 2009-and that is even before the decline, even before 2008, it’s not as if the government budget situation was rosy. I had a PhD student in the late ’90s whose thesis was motivated by dire predictions, by so-called intergenerational accounting specialists who claim that because of the projected retirement of baby boomers starting in before now in fact, once that started happening the government budget constraint was in such a bad shape taxes had to rise. This was before all the bad stuff happened, now they’ve engaged in the stimulus packages and the temporary tax reductions, they’re not huge amounts in the big picture, but they certainly don’t help the budget situation.

Arabic Knowledge at Wharton: Has the so-called ‘double-dip’ recession occurred or is there potential for it to occur?

Kydland: According to the data, it hasn’t happened in the sense that real GDP hasn’t started falling. But in a sense, I like to look at it relative to trend. And we’ve been moving further away from this trend. We already dropped by 10 or 12 percent in 2008-2009, and growth rates of around 1 percent or whatever they have been, that’s not enough to start moving back towards trend. So even without an actual dip, that’s still pretty bad.

It’s dismal enough, because you would like some kind of a springing back from that bottom. Normally, that would reasonable to expect and so I think policy-makers have to be really inept to essentially prevent that from happening.

Arabic Knowledge at Wharton: Turning to this region, with the onset of the Arab Spring, there are some countries completely reinventing themselves. We wondered if you had any insight on these emerging economies and how they might develop and what role they might have on the global stage?

Kydland: I don’t have any data on which to base any assessment. One thing I know is if you sum up economic activity in all the Arab countries, if you see them as one bloc of nations, that’s pretty sizeable in terms of total population, potential for economic activity and so on. And it’s certainly something that I think the Untied States and Europe should pay attention to, not just India and China, but the combination of Arab countries. I know in the United States it may not be very popular among the public in general, I think that sort of a sentiment is very irrational; and probably in Europe they’re more amenable to interaction with Arab nations. And I think they should. I think it’s in everyone’s interest that these nations, now that they’ve acquired more freedom, that one trades with them and I think it’s in everyone’s interest that they develop at reasonable speeds and grow reasonably fast.

Arabic Knowledge at Wharton: What do you think of the development model of the United Arab Emirates and other Gulf countries? Do you think it’s viable?

Kydland: I admit that I don’t know enough. One thing I would like to know more about is does this region grow because of competitive activity, entrepreneurial activity among its citizens or is it the government deciding where to develop? I admit that I’m somewhat suspicious about governments being the ones thinking they know where to go, because there’s lots of experience about bad incentives being in action when that happens, unlike economic activity that developed naturally through well-functioning banking system, entrepreneurs either having their own funds but also to some extent getting funding for profitable projects. They tend, by and large, I think they see more clearly where the profitable opportunities are than the government. But at the same time, it does seem that the UAE, for example, they are trying to put an environment in place with good infrastructure and so on where such private activity is permitted to flourish and it makes it easier and so on. In absent (of) any hard and fast evidence, I suppose that’s the potential rosy picture I can paint and maybe that’s realistic.

Arabic Knowledge at Wharton: When it comes to other emerging economies, what comes to mind when you observe India and China? What could their impact be on the global economic order?

Kydland: First of all, I think India and China, for example, you mentioned them, they deserve to grow. If you look at income per capita in both nations it’s not very high. I mean China I believe it’s still under US$10,000 a person, and in the United States and in more well-to-do European nations it’s four times that. The recommendation that I would make about India, to ensure that they do well in the longer run, would be to remove much of the bureaucracy. …There’s a ranking put out every year about how many days or how much resources is needed to set up a new company in various countries and India ranks pretty low. So they can do pretty well for a while but in the long run that’s an issue they probably need to solve.

In China also, I think the greatest problem is that too much is state-run. The banks are state-owned, there are virtually no private banks; there are state-owned companies, they have easy access to loans from the state-run banks. And meanwhile, as we talked about earlier, the key to long-run growth is usually entrepreneurial activity. And in China, I learned from a paper by a former student of mine, his name is (Kjetil) Storesletten, he published a paper in the American Economic Review, one of the top three journals in economics last year, "Growing Like China" was the title. So I learnt a lot from that article, and what I learnt there was that it seems that entrepreneurs, in order to engage in their activity, they need to save up first. In other words, it’s difficult for them to get loans for their activity and also because of that they’re pushed into or they’re biased towards more labor-intensive activities. And if that continues, it’s not good for the long-run of the nation. Meantime, the large companies, because of the easy access to loans, because of the easy access to cheap labor they can show sizeable profits even if what they do is not necessarily that productive. But that sort of thing cannot continue forever, I don’t think. And so I think for China to do really well in the long-run, they would have to open up for more competition in the banking sector. That’s sort of a conclusion I drew from reading that article by Storesletten.

Arabic Knowledge at Wharton: Do you find any holes or gaps in the way institutions are training or educating students within the field of economics? Is there anything that needs to be recalibrated at the graduate level?

Kydland: I’m quite optimistic. It used to be that the United States really had a dominance in training potential professors for the doctoral thesis or their research training. I’m encouraged by the trend in Europe to improve the research training in most countries. Many European nations have this arcane form of a doctoral degree, where you basically sat on your own without any courses or anything and tried to come up with a dissertation, or very few courses. So I think many European countries have moved more in the direction of adapting a similar system as the one in the United States that has been shown to function well. Of course, there are ways of improving any such way of training.

Where I used to be at Carnegie Mellon (University), they had a very unique form of doctoral training, where they relied less on courses and more on learning by doing, early on in their studies. So students are required to write their potentially publishable research paper in the first summer and another one in the second summer, and many of these get published. But it helps that their doctoral program is small. So when I’ve suggested it for some of the bigger places they say there’s too much variability in the research potential of their students and just so many of them run into the fact that it would be difficult to do. But I know it’s also been done at the business school in Stanford and so on. So those are minor things that if they could be adopted by other places would make the research training even more efficient. But I think by and large, it’s greater this improvement in the quality in Europe, especially this recent phenomenon, and a good phenomenon.

Arabic Knowledge at Wharton: Is there any room for improvement with how general economics is taught at the introductory stages, say at the undergraduate level or in businesses schools?

Kydland: I don’t think there are any complaints about microeconomics. But macroeconomics, I always tell the students from the beginning, all the interesting phenomena in macroeconomics are dynamic, they’re forward-looking. That might be a slight overstatement, but by and large that’s true. Dynamic macroeconomics is difficult to do on paper, and for that reason, many undergraduate textbooks I think are lacking in the training they give the students in that sense along that dimension. And I’ve thought a bit about what could be done about it: if it’s hard to do on paper, then what you do?

One thing I’ve taken the initiative, with the help of information system experts, is to take the web or computer into use or let the computer help you help the students see the dynamics of what happens, if response to shocks to the economy let’s say, look at the propagation of these shocks in a form of impulse responses as we call them and so on. I’ve used that approach myself with some luck. Certainly the top half of the class tends to be enthusiastic about that, it tends to be a little difficult for some students. There’s always a tradeoff. But I think it’s important to give the students the sense of the forward-lookingness or the potential importance of the expectation by future government policy, for example.