Why Did Sargent and Sims Win the Nobel?

Before we get to the meat of the post today, we felt like there would be no better time than the present to echo the words of one of our more fastidious (and slightly curmudgeonly) past professors by saying that there is no Nobel Prize in economics. There is rather a Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel which was established by Sweden's central bank in the late sixties. This differs from the Nobel Prizes in chemistry and physics which were established and funded by Alfred Nobel in his will in the late 1800's. Nonetheless, as the honor is awarded by the same body, is typically referred to as the Nobel Prize in Economics by everyone from your grandmother to the awarding committee, has the name 'Nobel' in the official name and is, like the others, incredibly prestigious, public confusion can be forgiven.

For those who haven't been following news today, the stimulus for that short anecdote is that the winners of the 'not' Nobel (in the words of the aforementioned professor) were announced today. Thomas J. Sargent of NYU and Christopher A. Sims of Princeton were the recipients of the honor this year for their work on how shocks and more systematic changes impact macroeconomic variables in both the short and the long run. For those who would like more than this one-liner, we have taken the liberty of taking some select passages from today's public press release to help our readers understand the basics on Sargent and Sims' research:

The economy is constantly affected by unanticipated events. The price of oil rises unexpectedly, the central bank sets an interest rate unforeseen by borrowers and lenders, or household consumption suddenly declines. Such unexpected occurrences are usually called shocks. The economy is also affected by more long-run changes, such as a shift in monetary policy towards stricter disinflationary measures or fiscal policy with more stringent budget rules. One of the main tasks of macroeconomic research is to comprehend how both shocks and systematic policy shifts affect macroeconomic variables in the short and long run. Sargent’s and Sims’s awarded research contributions have been indispensable to this work. Sargent has primarily helped us understand the effects of systematic policy shifts, while Sims has focused on how shocks spread throughout the economy.

One difficulty in attempting to understand how the economy works is that the relationships are often reciprocal. Is it policy that influences economic development or is there a reverse causal relationship? One reason for this ambiguity is that both private and public agents actively look ahead. The expectations of the private sector regarding future policy affect today’s decisions about wages, prices and investments, while economic-policy decisions are guided by expectations about developments in the private sector.

A clear-cut example of a two-way relationship is the economic development in the early 1980s, when many countries shifted their policy in order to combat inflation. This change was primarily a reaction to economic events during the 1970s, when the inflation rate increased due to higher oil prices and lower productivity growth. Consequently, it is difficult to determine whether the subsequent changes in the economy depended on the policy shift or on underlying factors beyond the control of monetary and fiscal policy which, in turn, gave rise to a different policy. One way of studying the effects of economic policy would be to carry out controlled experiments. In practice, however, varying policies cannot be randomly assigned to different countries. Macroeconomic research is therefore obliged to use historical data. The laureates’ foremost contribution has been to show that causal macroeconomic relationships can indeed be analyzed using historical data, even in cases with two-way relationships.

Some of Sargent’s contributions were solely methodological, although he has also applied the new methods in highly influential empirical research. For instance, he has analyzed historical episodes of hyperinflation in different European countries. He has also examined the above-mentioned course of events in the 1970s when many economies initially adopted a high-inflation policy and then reverted to a lower rate of inflation. Sargent showed that the way expectations are formed by the general public as well as central banks’ understanding of the inflation process were based on gradual learning. This could explain why the decline in inflation took such a long time.

The difference between forecast and outcome – the forecasting error – for a specific variable may be regarded as a type of shock, but Sims showed that such forecasting errors do not have an unambiguous economic interpretation. For instance, either an unexpected change in the interest rate could be a reaction to other simultaneous shocks to, say, unemployment or inflation, or the interest-rate change might have taken place independently of other shocks. This kind of independent change is called a fundamental shock.

The empirical strategies proposed by Sargent and Sims are intercomparable. In order to study the impact of systematic policy changes on the economy, Sargent’s method requires specific assumptions about thestructure of the economy – assumptions that may be questionable. The assumptions underlying a VAR model, on the other hand, are more general and hold across a wide class of economic models. Researchers have a choice of method depending on the application. With detailed knowledge about the structure of the economy, Sargent’s method may be preferable, in particular since it allows a counterfactual analysis of systematic changes in economic policy. When knowledge of the field is less exact, Sims’s method may be safer.