Thomas Sargent and Christopher Sims deserve the Nobel Prize for their work even if it is so complex or abstract that it is hard to explain to undergraduate economics majors, much less to the general public. So it perhaps is best to start with a very brief historical review of economic thought that led up to their work.
From publication of Adam Smith’s The Wealth of Nations in 1776 until 1936, the standard prescription was that it was best for government to keep its hands off the economy. Recessions might occur but market forces would also end them. Government intervention would only make things worse.
John Maynard Keynes’ General Theory broke with 160 years of that orthodoxy to argue that there were times when government could and should act to reduce the economic fluctuations we call the business cycle. Given that he wrote in the depths of the Great Depression, 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, that 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 were also 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, then at Carnegie-Mellon, all were under 40.
Keynesian policies depended on government manipulating overall or “aggregate” demand in an economy by changing taxes, 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.
Beyond that, attempts at explaining their ideas for lay audiences become difficult. The Nobel Committee’s four-page “Information for the Public” and 41-page “Scientific Background” documents do a pretty good job. They're available at http://www.nobelprize.org/nobel_prizes/economics/laureates/2011/press.html.
(One can also learn from interviews with Sargent in 2010 and Sims in 2007 in The Region magazine published by the Minneapolis Fed at http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4526 and Sims http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3168)
In the late 1940s, Paul Samuelson, the 1970 Nobelist who died in 2009, 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 some theorizing.
Although Sargent was at Minnesota for 16 years and Sims 20, both moved on to greener pastures 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, a budget that is balanced over the business cycle, inflation will necessarily result.
This is not yet accepted by most other economists, but I’ll predict that it will withstand the test of time better than most of the work of this group.
Wags note that when people start to get Nobel prizes for a particular set of theories, it is a sure sign that the theory is dead. A raft of Keynesians got Nobels in the late 1970s and early 1980s even as a younger generation refuted their life work. The stagflation of the 1970s motivated this swing away from Keynes, and the events of the last four years may provoke a swing away from today’s orthodoxies. The 2030 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.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.
