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The Economist: Understanding Causes and Consequences

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The author of this entry is responsible for this content, which is not edited by the Wilson County News or
Dr. M. Ray Perryman
October 12, 2011 | 1,954 views | 2 comments

In 1968, the central bank of Sweden instituted the Nobel Prize in Economics. Formally “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel,” the prize has been awarded every year since that time by the Royal Swedish Academy of Sciences. The $1.5 million prizes have been given for work in economics areas ranging from general equilibrium theory (how everything hangs together) to traditional micro and macroeconomics to bargaining theory to economic history. Economists who have expanded the field of economics into other arenas such as political science, sociology, and law have also been recognized.

At times, awards have been based on a single specific contribution (or even several contributions); in other cases, a lifetime of work results in the distinction of being a Nobel laureate. The criteria for selection include the originality of the contribution, its scientific and practical importance, and its impact on scientific progress. The effects of the work on society and public policy also play a role in the choice of recipient(s).

Many of the persons honored have contributed much to the science of economics, but in such a way as to be highly mathematical and difficult to comprehend outside the arcane world of theoretical economics, even for reasonably well-informed persons. Sometimes, the relevance of the work can be difficult to grasp without having studied the subject matter intensely (such as contributions dealing with the analytical structures of theoretical economic models or the role of information asymmetries in alternative allocation mechanisms). Not so this year; instead, the work of the two winners is directly related to a subject near and dear to virtually everyone’s heart: improving the pace of economic growth and formulating policies to avoid another recession.

The 2011 Nobel prize winners in economics are Thomas Sargent and Christopher Sims. The two Americans carried out much of their research in the 1970s and 1980s (independently of each other, though the topics are complementary) and now teach at US universities (Sargent at NYU and Sims at Princeton).

Sargent and Sims developed methods for describing how either short-term shocks to the economy (such as a sudden oil price hike or a natural disaster) or long-term changes (such as central bank interest rate policy) translate into economic growth. These methods are essential tools in macroeconomic analysis and are widely and frequently used by central banks in formulating policy and projecting future conditions.

In essence, these men helped define (in mathematical terms) the role of expectations and the cause-and-effect relationship between the economy and policy instruments. They helped develop methods to measure and analyze (and attempt to predict) the myriad ways people respond to economic policy. Given that there are multiple things affecting the economy at any particular time, it can be difficult to determine which is causing what. Moreover, most of these relationships work two ways, with central banks’ actions affecting investors, for instance, and investor actions, in turn, leading to alteration in central bank policy. To complicate matters further, the expectations of various actors in the economy also play a role. Sims, along with prior Nobel winner Clive Granger, helped us to sort out a lot of the causal relationships in a more systematic manner.

Given the complexity of these relationships, it is important to have tools to analyze them. For example, if a central bank decreases interest rates, will the result be better economic growth? If so, how much? If a government spends trillions for a stimulus package, what are the likely benefits in terms of economic performance? If tax rates are reduced, will tax revenue also decline or could it, in fact, increase thanks to the stimulative effects of the reduction and associated gains in business activity? Sargent, along with earlier winner Robert Lucas and several others, made us rethink expectations and the role they play in fundamental ways.

Economic policy should be crafted with as much (and as reliable) a picture of the potential economic outcomes as is possible to obtain. The work of this year’s Nobel prize winners helps shed light on the most effective methods for modeling the underlying relationships (including sorting out cause and effect components and the role of expectations). As central banks around the globe work to tweak policy and speed economic growth and avoid another recession, the foundational work by these notable scholars is in daily use.

While differences in political ideals influence policy prescriptions, it is far preferable to have some empirical, statistical, and mathematical basis for them, using past experience to inform current and future action. For their contributions in these areas, this year’s Nobel laureates should have our sincere gratitude.

Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.
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Your Opinions and Comments

Rock'n chair Rambler  
Over Taxed, TX  
October 13, 2011 6:43am
Here's a pretty accurate economic theory for ya.... If you find yourself in a hole, the first thing to do is stop diggin'. That's the only thing our politicians need to know.

Elaine K.  
October 12, 2011 10:59am
New column posted.

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