Economists’ lifetime of work honoured with Nobel prize

Joint Nobel Prize in Economics winners Christopher Sims and Thomas Sargent have contributed a body of work over decades. AAP

Princeton University professor Christopher Sims and New York University economist Thomas Sargent have been jointly named the 2011 winners of the Nobel Prize in Economics (or, for the purists, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel).

Sargent is widely known for his pioneering work on “rational expectations” - how consumers change their behaviour in line with economic policy - while Sims’ modelling work has been globally adopted by central banks.

Associate Professor Andrew John of the Melbourne Business School explains some of their most significant work and how it can help us understand the current global upheaval.

Thomas Sargent is someone who has been expected to receive the Nobel for some time. He is highly respected and admired in the profession, with a vast volume of important work to his name.

One of the things that makes the social sciences - like economics - hard is that they deal with people. People look ahead – they make forecasts, they form expectations, and they behave on the basis of those forecasts. So if something happens to change peopleʼs expectations about the future, that affects how they behave today.

Fifty years ago, our macroeconomic models did not do a very good job of dealing with these expectations. They relied instead on aggregate relationships between variables.

For example, the data might show that when the central bank increases the money supply, real GDP goes up. The trouble was that policymakers then assumed this was a relationship that could be exploited: They said Aha! That means that if we increase the money supply we will increase GDP. But it doesnʼt necessarily work that way.

Perhaps if a central bank increases the money supply people will instead change their expectations. They will think that there is going to be higher inflation, and so workers will start looking for higher wages and firms will set higher prices. In this case, the increase in the money supply will lead to inflation instead of growth.

“Policy ineffectiveness”

This fundamental problem was most famously articulated by Robert Lucas, who won the Nobel prize several years ago. But Sargent, together with another economist named Neil Wallace, showed that there are in fact circumstances in which monetary policy is completely ineffective in changing GDP, even if a naive look at the data would suggest that it does have an effect.

This so-called “policy ineffectiveness” result is one of Sargentʼs best known contributions. In turn, this led to a new way of doing empirical work in macroeconomics, in which Sargent was a pioneer.

In particular, Sargent argued that macroeconomic models should be structural, meaning that the basic relationships in the model should stay the same when policy is changed. Such models should be based on the underlying behaviour of individuals and firms in the economy, rather than on aggregate relationships in the data.

Sargent also argued that macroeconomic models should include “rational expectations,” which insists that the forecasts that people make should on average be correct - and consistent with the model.

Rubbish piles on Greek streets during a workers’ strike protesting austerity measures. AAP

Monetary and Fiscal policy

Sargent is known for much more than his work on structural macroeconomic models, however.

His papers on the connections between monetary and fiscal policy are highly relevant for understanding the current situation in Europe and perhaps also in the United States.

Essentially this work says that monetary policy (the choices a central bank makes about money and interest rates) and fiscal policy (the choices politicians make about spending and taxes) are interconnected. They are linked because there are three ways that a government can finance its activities. It can levy taxes. It can borrow. Or it can print money.

One place we see this connection is when economies suffer from hyperinflation. Think about a government that is spending money, but is unable to raise enough current taxes to pay for that spending. It can try to borrow, but borrowing is just deferred taxes. People will only be willing to lend to the government if they are confident that it will be able to obtain the tax revenue in the future.

A government that finds itself unable to raise funds through taxes or borrowing has only one option left, which is to print money. And though it is not good economic policy, it is understandable enough - particularly for governments that have a shaky grasp on power. Better to risk inflation than not to pay your army!

“Unpleasant arithmetic”

Sargent studied four of the big hyperinflations in the first half of the 20th century, and showed that those hyperinflations were only ended when fiscal reforms were enacted. Though the proximate cause of hyperinflation is excessive monetary growth, the ultimate cause is fiscal problems.

European Central Bank designated head Mario Draghi. AAP

In another very important paper - entitled Some Unpleasant Monetarist Arithmetic - Sargent (again with Neil Wallace) argued that if the fiscal policymakers run unsustainable debt, then sooner or later the monetary authority will be forced to bail it out by printing money.

Again, the key insight is that monetary and fiscal policy cannot be considered independently of each other.

Indeed, the connection between monetary and fiscal policy was one of the reasons why, when the euro was established, governments had to sign up to the constraints on fiscal policy in the Stability and Growth Pact (SGP).

This agreement placed limits on the size of government debt and government deficits, in part so as to prevent the European Central Bank [ECB] from coming under pressure to generate monetary growth.

Of course, these limits were repeatedly violated and it is even possible that the SGP ended up having the opposite effect from what was intended. It implied a degree of fiscal unity [not union] that did not really exist.

As a result investors may have viewed Greek sovereign debt as safe for too long because they trusted the EU to provide fiscal discipline. Had they simply viewed the risk of that debt as linked to the Greek governmentʼs fiscal policy, alarm bells might have gone off sooner.

And as Sargent pointed out in an interview last year, “The banks located in the center of the euro area, France and Germany, hold Greek-denominated debt, so a threat of default on Greek government debt threatens the portfolios of those banks in other European countries. Because it is the lender of last resort, now it is the ECB’s business.”

While I am not one of those who sees any immediate risk of inflation in the United States, Sargent and Wallaceʼs argument about unsustainable fiscal policy also seems to be becoming more and more relevant to the United States.

The point is not so much that the United States is currently running deficits, or that it has a large debt-to-GDP ratio (although it is and it does). The point is that the political climate in the United States makes it hard to see this fiscal imbalance being corrected any time soon.

While the markets still currently view US Treasuries as very safe assets, it is conceivable that there could come a time when that would change.

US political climate is contributing to a fiscal imbalance. AAP

At the same time, there are some hints that the Federal Reserve is coming under increased political pressure. Those are the kinds of circumstances where Sargent and Wallaceʼs unpleasant monetarist arithmetic may eventually bite.

Sargent’s other work

This is by no means an exhaustive catalogue of Sargentʼs work, or even of his important work. He is a highly prolific economist who has written dozens of significant papers.

He has made important contributions to research on learning and computation, for example. He has also written about how unemployment insurance can have unanticipated negative consequences: generous unemployment benefits make people less likely to take new jobs quickly, and their skills (“human capital” in economic jargon) may decrease.

Atheoretical approach

Christopher Sims, the other Nobelist, is largely known for a couple of very important papers.

Like Sargent, Sims also addressed the question of how to model the macroeconomy. His starting point, again like Sargent, was that the typical models of the 1960s were very ad hoc and difficult to defend. And like Sargent, Sims thought these models were badly flawed because of their treatment of expectations.

But where Sargent turned to models that probed deeper into the structure of the economy, Sims went in the other direction, taking a relatively atheoretical look at the data.

For example, we might be interested in the behavior of GDP, interest rates, money, and inflation. Sims asked: to what extent can we explain the current values of these variables just by looking at their past values? This is a statistical technique called Vector Autogression (VAR), which is now widely used - not just in macroeconomics, but in other subfields of economics as well.

Sims originally hoped that this approach could be implemented purely as a description of the data, without relying on theoretical restrictions at all. The idea, for example, was to use this technique to ask what change in GDP would result from a change in the money supply. It turned out to be a bit more complicated than that (technically, some restrictions were still needed), but the models were still much more robust than earlier approaches.

Sims’ techniques also helped economists trace out the effects over time of “shocks” to the economy" For example, suppose there is an unexpected decrease in the central bank’s policy rate. VARs allow us to see how this change results in dynamic adjustment of GDP and inflation.

“Granger-Sims causality”

Related to this is Simsʼ work on causality. He and another past Nobel laureate (Clive Granger) approached the notion of causality in terms of predictive power. So-called Granger-Sims causality is again essentially an atheoretical idea: we say variable A causes variable B if changes in variable A help us predict changes in variable B.

Sims’ contribution was technical, but it has had an enormous impact. His approach to economic modelling is routinely used by academic researchers and by economists formulating policy in Central Banks.

Modern dynamic models of the economy make extensive use of the VAR techniques that Sims developed. There is no doubt that he, too, is a deserving winner of the prize.

It’s not about politics

As a final note, commentators often seem tempted to place a political spin on Nobel prize announcements. For example, when Paul Krugman was awarded the prize three years ago, many took this to be an endorsement of Krugman’s liberal political commentary. I make no claim to know the inner musings of the Nobel prize committee, but for what it is worth, I think such discussion is beside the point.

Both Sargent and Sims are associated with the relatively conservative “Minnesota school” of macroeconomics, but to identify them as right-wing economists, or to think of this prize simply as an endorsement of conservatism, would be a gross disservice to their contribution and indeed to their nuanced views.

I am confident that almost all macroeconomists, whatever their personal political views, would view Sargent and Sims as excellent choices for this year’s Nobel prize, and would happily raise a glass in their honour.