This Year’s Nobel Prize Winners in Economics: Skeptics and Supporters

BY Paul Solman  October 12, 2010 at 10:21 AM EDT

A few words about the Nobel Prize in economics and this year’s winners.

First, the skeptics.

Making Sense

They are eager to point out that the prize in economics is actually the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, created by Sweden’s national bank in 1968 and not, technically, a “Nobel” prize at all. The skeptics argue that it is the economics establishment’s way of boosting its own reputation.

Moreover, they say, it treats economics as a “science,” when in fact it’s more nearly a social so-called science with little ability to do what science fundamentally does: perform experiments and make durable predictions.

No wonder (say the skeptics) that economics is rife with “physics envy” and ties itself into knots using mathematics to analyze human behavior, thereby wildly oversimplifying the world of getting and spending.

And no wonder that the Royal Swedish Academy of Science usually confers its “Nobel Prize” on economists with abstruse mathematical models that have both oversimplified and overcomplexified the world at the very same time.

One of Monday’s economic “Nobel” laureates stands as a living refutation of the skeptics. MIT’s Peter Diamond, (pictured right) notable of late for having his nomination to the Federal Reserve Board held up by Republicans, is an economist who has used his considerable math skills to try to make the world a more manageable place.

His excitement about economics is its ability to study real-world phenomena and come up with policy solutions based on such analysis.

Is he rigorous? Intimidatingly so. Are his papers impossible for a layperson to follow, much less to evaluate? Often. But in his work on Social Security, for example, Diamond couldn’t be more straightforward, illustrating clearly and convincingly how the system can be saved with relatively modest adjustments to both taxes and benefits, though some might argue that they’re not all modest in the end. He even co-wrote a book to make the case. No math needed, beyond simple arithmetic.

As is typical with the economics Nobel, the prize is given for a particular line of inquiry within the profession that has triggered subsequent work. One year it was “behavioral economics”; another, “financial engineering”; yet another, “asymmetric information.”

This year the prize goes to “matching theory”: the analysis of how economic trades — of labor or goods — can be more complicated than simply “lowest price wins.”

Under the simplest economic assumption, which has long dominated the discipline, markets work like a charm. Price is the signal of how dearly any given product or person’s work is desired, given the resources we have. Since markets are competitive, that price will always wind up as a signal leading to the most efficient use of those resources.

So if gasoline costs $3 at the pump today, that’s the price which supposedly signals just the right amount of to be supplied today, given the cost of producing the gas and the public’s desire to drive, its command over other resources to pay for the gas, and so on. It’s as if, as one economist famously said, there’s an invisible auctioneer out there, constantly putting up goods for bid and, via prices, getting the most efficient allocation of the resources we’ve got.

But there is no invisible auctioneer. And, as Peter Diamond tried to demonstrate in a mathematically driven paper back in 1982, which the prize committee cited today, it’s not all that easy to MATCH buyers and sellers. They don’t all come together in some central auction room to bid, based on today’s prices and situation. They have expectations about the future — including their very own future.

Take today’s job market, with an unemployment rate up near the previous post-WWII high reached in 1982, the year of Diamond’s paper. (There’s an argument that today’s rate is actually higher, as we’ve explained here and here.) According to the invisible auctioneer model, workers are offering their services on the open market and employers are simply not hiring them because their price is too high, given what they bring to the table (or firm).

But suppose firms would hire workers at the wage they’re asking, but don’t — because of pessimistic expectations about the future. The Diamond Match company, say, might hire unemployed workers to run its idle match machine — but only if it expects sales to go up in the future. Problem is, those very same workers also have expectations: that they won’t get a job anytime soon. So they, and millions like them, have cut back on expenditures, including cigarettes and, therefore, matches. This lowers the expectations of Diamond Match, which then doesn’t hire them or even lays off more workers, dampening worker expectations even further.

You may notice the similarity to the famous insight of English economist John Maynard Keynes during the Great Depression of the 1930s. He wrote that large-scale economic activity boils down to expectations or, as he provocatively called them, “animal spirits.” A Depression is when those spirits are dampened drastically for workers and firms alike. The policy prescription is government spending to raise expectations, and get firms hiring. Then the workers will have the money to spend on matches, etc.

It’s like two people on either side of a lake who’d both be better off if they swam to the island in the middle, says Boston University economist Larry Kotlikoff. With no one to coordinate their actions, each decides to swim or not based on the expectation of what the other person will do. It’s not hard to see that low expectations would keep both stuck to the shore.

Peter Diamond’s career has been an exploration of markets and optimal government policies. He’s both a deep theorist with math skills to burn (or so I’m told) and a practical economist devoted to making the world a better place. President Obama will resubmit his name for Vice-Chairmanship of the Fed when Congress reconvenes.

P.S.: There are posts about Diamond by Steven “Freakonomics” Levitt and Tyler “Marginal Revolution” Cowen. The latter, a well-known blogger, columnist, economist and libertarian, sees the prizes to Diamond’s fellow winners, Dale Mortenson of Northwestern and Christopher Pissarides of the London School of Economics as a rejection of interventionist Keynesianism, the school of thought that Keynes inspired. If you want to get a sense of how lingo-laden discourse can be within the economics siblinghood, trying reading it.

It might be noted, however, that both Mortenson and Pissarides echoed Diamond in remarks they made today, remarks that run counter to Cowen’s post in that all three said now is the time to create jobs and that friction in the labor market–the problem of matching–makes that more imperative, not less. The problem noted by all three: the longer people are out-of-work, the greater the problem to match them with jobs.

This entry is cross-posted from the NewsHour’s Making Sen$e page, where business and economics correspondent Paul Solman answers your questions on economic news. Follow Paul on Twitter.

Photo of Peter Diamond by MIT