Thomas Sargent and Christopher Sims did the work that earned them the Nobel Prize in economics in their years in Minnesota. But, like their former colleague Ed Prescott, who won in 2004, Sims and Sargent moved on to greener fields before getting their well-deserved prize.
But it’s interesting to note that at the time they did their work, Minnesota was more receptive to new ways of thinking about how to handle the business cycle than some of the bigger-name schools.
Let’s back up a bit with a very brief historical review.
From publication of Adam Smith’s “The Wealth of Nations” in 1776 and until 1936, the standard economic thinking was that it was best for government to keep its hands off the economy. Recessions might occur but market forces also would end them. Government intervention would only make things worse.
In the depths of the Great Depression, John Maynard Keynes broke with that orthodoxy to argue that there were times when government could and should act to reduce the economic fluctuations we call the business cycle. His ideas quickly won over the discipline and became accepted wisdom for the next generation.
But by the 1970s, it seemed to some young economists that Keynesian policies to manage the business cycle were counterproductive. Their work, which became the “rational expectations revolution,” included that done by Robert Lucas at the University of Chicago, long an economics powerhouse. But second-tier schools like Minnesota and Carnegie-Mellon also were hotbeds of the new theory while bigger-name schools like Harvard, Yale and Princeton remained dominated by Keynesianism.
At Minnesota, three young faculty members, Neil Wallace, Tom Sargent and Chris Sims, broke the path. Like Lucas and like Prescott, who was then at Carnegie-Mellon, all were under 40.
Keynesian policies depended on government manipulating overall or “aggregate” demand in an economy by changing taxes and government spending, together with the money supply, and hence interest rates. But these young critics argued that the success of such policies depended on the general population acting like sheep whose wool could be pulled over their eyes again and again by Keynesian efforts to expand or contract consumption and investment.
If people are rational, as economic theory had assumed since 1820, and base their decisions on the expected outcomes of Keynesian policies, the actions that millions of individuals would take to protect their own interests collectively would nullify the promised outcomes of these policies. “Fiscal stimulus programs” would not, for example, stimulate. Repeated attempts to lower unemployment with easy money would lead to both high unemployment and high inflation.
Briefly, Sargent developed a model for describing the economy in mathematical terms, then looked at expectations for how variables such as inflation would change and used historical data to analyze the impact of changes in economic policy.
Sims also emphasized the importance of expectations, but he focused on how unanticipated events, such as a change in the price of oil, influenced macroeconomic data. Such unanticipated events, which also could include interest-rate changes or a sharp increase or decrease in consumer spending, are known as shocks. Sims introduced a new way of analyzing macroeconomic data that extracts the shocks to which the economy has been imposed.
(For a longer summary of Sargent’s and Sims’ work, go to www.nobelprize.org/nobel_prizes/economics/laureates/2011/press.html.)
Paul Samuelson, the 1970 Nobelist who died two years ago, had led economics into an era expressing theories in complex, formal mathematical models. The development of computers and of econometrics, the application of statistical methods to test economic theories with real data, gave new analytical power to the discipline.
The rational expectationists took both such theorizing and such analysis to new levels. It is partially correct to say that Sargent was the macro theorist and Sims the econometrician. But Sargent’s work necessarily involved econometrics and that of Sims’ theorizing.
Although Sargent was at Minnesota for 16 years and Sims 20, both moved on to other institutions and, to a degree, other problems in economics. Sims, in particular, has broken with the conventional wisdom that inflation is determined almost entirely by the money supply. His “fiscal theory of the price level” is particularly applicable to problems today. It argues that if a government does not maintain fiscal discipline and a budget that is balanced over the business cycle, inflation will necessarily result.
This is not accepted by most other economists. Narayana Kocherlakota, who came to the University of Minnesota after Sims left and who now heads the Minneapolis Fed, is one noted critic of this line of thought.
Wags note that when people start to get Nobel Prizes for a particular set of theories, it is a sure sign the theory is dead. A raft of Keynesians got Nobels in the late 1970s and early 1980s even as a younger generation refuted their lifework. The stagflation of the 1970s motivated this swing away from Keynes and the events of the past four years may provoke a swing away from today’s orthodoxies.
The 2030s Nobels will say something about the durability of the work of Sims, Sargent, Prescott and Lucas. If history is a guide, some of their most tightly defended ideas will appear quaint, but others will prove to be lasting wisdom. We just don’t know which will be which.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.