The Nobel Prize in Economics in 2011 was jointly awarded to two leading economists, Thomas Sargent of the New York University and Christopher Sims of Princeton University, last week by the Royal Swedish Academy of Sciences on the advice of Economics Sciences Prize Committee.
Unlike the other Nobel Prizes which are announced by the Oslo-based Nobel Foundation, the Nobel Prize in Economics is announced in Stockholm, capital of Sweden, since it is a prize established by Sveriges Riksbank, the Central Bank of Sweden, to mark its 300th anniversary that fell in 1968.
The Economics Sciences Prize Committee has justified the selection of Sargent and Sims for this high accolade on the ground of their ‘contribution to developing relationship between macroeconomic policy making and macroeconomic variables’.
In laymen’s language, what it means is that the two economists have studied the impact of budget deficits run by governments by resorting to borrowing from people and abroad and printing money through central banks and the central banks’ own policies of changing interest rates to fight inflation (representing macroeconomic policy) on creating jobs, increasing production and prosperity of people, lowering cost of living and contributing to strengthening of exchange rates (macroeconomic variables) and have left the policy makers with a set of policy guidelines to follow.
Though it appears to be a simple exercise, the underlying reasoning and the theoretical underpinning of their research, done separately and independently, are complex and, therefore, not easy to comprehend.
There are some strange coincidences relating to the two Nobel Laureates. Both are 68 years old when they were selected for this high accolade, had done their PhDs at Harvard University in 1968 and are reported to have been taking a joint lecture in macroeconomic policy at Princeton University when they were reached by the Nobel Prize Awarding Committee to give them the happy news.
Freshwater economics versus saltwater economics
In laymen’s language, what it means is that the two economists have studied the impact of budget deficits run by governments by resorting to borrowing from people and abroad and printing money through central banks and the central banks’ own policies of changing interest rates to fight inflation (representing macroeconomic policy) on creating jobs, increasing production and prosperity of people, lowering cost of living and contributing to strengthening of exchange rates (macroeconomic variables) and have left the policy makers with a set of policy guidelines to follow.
Though it appears to be a simple exercise, the underlying reasoning and the theoretical underpinning of their research, done separately and independently, are complex and, therefore, not easy to comprehend.
There are some strange coincidences relating to the two Nobel Laureates. Both are 68 years old when they were selected for this high accolade, had done their PhDs at Harvard University in 1968 and are reported to have been taking a joint lecture in macroeconomic policy at Princeton University when they were reached by the Nobel Prize Awarding Committee to give them the happy news.
Freshwater economics versus saltwater economics
Both Sargent and Sims belong to an economics school known as ‘the freshwater or sweetwater economics school,’ a term coined by economist Robert E Hall in 1976 to describe the body of economics that sprang up near and around the Great Lakes of the US and constituted principally the academics attached to Carnegie Mellon University and the Universities of Chicago, Rochester, Minnesota and Pittsburgh.
As against this school, a saltwater economics school too has been framed to describe the body of economics that was developed in association with universities located in both the East and the West coasts of USA such as Harvard, Massachusetts Institute of Technology, University of California, Berkley, Yale, Princeton, Columbia, Pennsylvania and Stanford.
Nobel Prizes had moved from saltwater to freshwater from time to time depending on the importance of the particular school’s ideology and prescriptions to sort out existing economic issues in the world, but this year’s recognition of the freshwater came after the lapse of some 16 years since its leading figure, Robert Lucas of the University of Chicago, was awarded the Nobel Prize in economics in 1995. Prior to that leading saltwater economists like Joseph Stiglitz and Paul Krugman had been recognised for awarding the Nobel Prize in economics.
Freshwater economists believe that markets are efficient
As against this school, a saltwater economics school too has been framed to describe the body of economics that was developed in association with universities located in both the East and the West coasts of USA such as Harvard, Massachusetts Institute of Technology, University of California, Berkley, Yale, Princeton, Columbia, Pennsylvania and Stanford.
Nobel Prizes had moved from saltwater to freshwater from time to time depending on the importance of the particular school’s ideology and prescriptions to sort out existing economic issues in the world, but this year’s recognition of the freshwater came after the lapse of some 16 years since its leading figure, Robert Lucas of the University of Chicago, was awarded the Nobel Prize in economics in 1995. Prior to that leading saltwater economists like Joseph Stiglitz and Paul Krugman had been recognised for awarding the Nobel Prize in economics.
Freshwater economists believe that markets are efficient
The freshwater school differs from the saltwater school in a number of ways they approach issues in macroeconomics, the branch of economics that studies an economy as a whole.
The freshwater school is principally a market based school and believes in markets’ self correcting ability to spring back to normalcy after suffering from a temporary setback or temporary displacement. Along with these self correcting markets, the economies concerned too would spring back to normalcy.
This is because they believe in the existence of efficient markets supported by rational decision makers who acquire all the information necessary for them to make decisions and those decisions are informed decisions based on carefully processed facts and not on emotions.
How does an economy spring back to normalcy without an outside push? Suppose that an economy faces a recession and it is necessary to bring it back to the normal growth path. The traditional prescription found in the popular body of economics knows as Keynesianism in such an event is for the government to step in and stimulate the economy to such a level so that it would reach its growth path once again.
But the freshwater economists believe that people who are bent on attaining the maximum for them, a notion known as maximisation objective of people and firms, will reallocate their resources to overcome the deficiencies and gradually take the economy back to its growth path. Thus, there is no necessity for them to wait for outside support.
Accordingly, they subscribe to ‘laissez faire type’ no government intervention economic policies. If the government intervenes, it not only causes a permanent damage to the economy by distorting its incentive structure but also prolongs the recovery process because of the new impediments such as regulations, laws etc it would create in the system.
The saltwater economists, on the other hand, believe that people are not rational, markets are not inherently efficient and people do not have all the information which they need to make decisions. Hence, there is a necessity for governments to intervene in the economies and such interventions are effective in speeding up the recovery of a sick – economy. So, they belong to the Keynesian school of economics.
And people form rational expectations
The freshwater school is principally a market based school and believes in markets’ self correcting ability to spring back to normalcy after suffering from a temporary setback or temporary displacement. Along with these self correcting markets, the economies concerned too would spring back to normalcy.
This is because they believe in the existence of efficient markets supported by rational decision makers who acquire all the information necessary for them to make decisions and those decisions are informed decisions based on carefully processed facts and not on emotions.
How does an economy spring back to normalcy without an outside push? Suppose that an economy faces a recession and it is necessary to bring it back to the normal growth path. The traditional prescription found in the popular body of economics knows as Keynesianism in such an event is for the government to step in and stimulate the economy to such a level so that it would reach its growth path once again.
But the freshwater economists believe that people who are bent on attaining the maximum for them, a notion known as maximisation objective of people and firms, will reallocate their resources to overcome the deficiencies and gradually take the economy back to its growth path. Thus, there is no necessity for them to wait for outside support.
Accordingly, they subscribe to ‘laissez faire type’ no government intervention economic policies. If the government intervenes, it not only causes a permanent damage to the economy by distorting its incentive structure but also prolongs the recovery process because of the new impediments such as regulations, laws etc it would create in the system.
The saltwater economists, on the other hand, believe that people are not rational, markets are not inherently efficient and people do not have all the information which they need to make decisions. Hence, there is a necessity for governments to intervene in the economies and such interventions are effective in speeding up the recovery of a sick – economy. So, they belong to the Keynesian school of economics.
And people form rational expectations
They also differ with respect to the way in which people make expectations about future events. The freshwater economists believe in people making rational expectations about the future, an expectation formation process which was first put into theoretical form by Carnegie Mellon University academic John Muth in 1961 and then further developed by Robert Lucas, Thomas Sargent and Neil Wallace among others.
Adaptive expectations: people can be fooled continuously
Adaptive expectations: people can be fooled continuously
Prior to Muth, the belief was that people made expectations based on their past experience and therefore if they had made mistakes in the past, some components of those mistakes were reflected in the expectations they had made about the future. The expectations are made on a trial and error basis and the mistakes made most recently which are still fresh on their mind would play a significant role in the new expectations they have formed.
People are aware of the mistakes they have made in the past but do not learn fully from those mistakes. Thus, when new expectations are formed, they do not fully eliminate the past mistake making only a partial adjustment on that account to the new expectations. These types of expectations were known as ‘adaptive expectations,’ so called because expectations are modified only to suit one’s requirements.
Since mistakes are a part of the expectations, those making adaptive expectations are supposed to make mistakes continuously. From a practical point of view, they do not learn fully from their past mistakes and therefore, can be fooled by others continuously.
Rational expectations: want to fool people? Forget it
People are aware of the mistakes they have made in the past but do not learn fully from those mistakes. Thus, when new expectations are formed, they do not fully eliminate the past mistake making only a partial adjustment on that account to the new expectations. These types of expectations were known as ‘adaptive expectations,’ so called because expectations are modified only to suit one’s requirements.
Since mistakes are a part of the expectations, those making adaptive expectations are supposed to make mistakes continuously. From a practical point of view, they do not learn fully from their past mistakes and therefore, can be fooled by others continuously.
Rational expectations: want to fool people? Forget it
But when one makes rational expectations, he learns from past mistakes and therefore does not make the same mistake twice. This type of behaviour perfectly conforms to the popular sayings ‘once bitten twice shy’ or ‘if one has fallen in to a pit in the dark, he should not fall in to the same pit in broad daylight’.
It is an explicit recognition that people make choices wisely; it is, therefore, recognition of the true nature of the Homo sapiens, the wise man. Hence, the freshwater economists believe that people cannot be fooled continuously and that behavioural trait places them in a position superior to governments and central banks.
The implication of this on macroeconomic policy is far reaching: if a government offers a stimulus package to speed up the recovery of a sick economy and if the funds for that stimulus package have come from either borrowing from the market or printing money, people immediately take account of its impact on their future.
Today’s borrowings make them pay more taxes in the future, while today’s printing of money will generate inflation in the future. Thus, in either case, they end up poorer than before. Once this factor is taken into their decision making, they find themselves indifferent to the stimulus package and therefore it does not serve as an incentive for them to work harder, the only way to speed up the recovery of a sick economy.
Consider also the plight of central banks under rational expectations. Suppose a central bank announces that in order to accelerate economic growth, it plans to double credit to private sector. The rational people would immediately infer that it will lead to an increase in money supply and inflation in the future.
High inflation would make them poorer if they do not take measures to protect them from the ill effects of inflation. Thus, they make higher expectations of inflation and incorporate that higher inflation into all new contracts they would sign, workers for wages and firms for outputs they deliver to customers. They also would invest in unproductive assets like land, real estates and gold to keep their wealth in a safer form.
This last action will create a bubble in the respective property markets and that bubble in no way contributes to an accelerated economic growth. Thus, the central would have doubled credit to private sector, but since it cannot fool people under rational expectations, it will not have a commensurate economic growth.
What it means is that since people are rational and form expectations rationally, neither authority can attain their policy targets by misleading them.
Sims and his Vector Autoregression
It is an explicit recognition that people make choices wisely; it is, therefore, recognition of the true nature of the Homo sapiens, the wise man. Hence, the freshwater economists believe that people cannot be fooled continuously and that behavioural trait places them in a position superior to governments and central banks.
The implication of this on macroeconomic policy is far reaching: if a government offers a stimulus package to speed up the recovery of a sick economy and if the funds for that stimulus package have come from either borrowing from the market or printing money, people immediately take account of its impact on their future.
Today’s borrowings make them pay more taxes in the future, while today’s printing of money will generate inflation in the future. Thus, in either case, they end up poorer than before. Once this factor is taken into their decision making, they find themselves indifferent to the stimulus package and therefore it does not serve as an incentive for them to work harder, the only way to speed up the recovery of a sick economy.
Consider also the plight of central banks under rational expectations. Suppose a central bank announces that in order to accelerate economic growth, it plans to double credit to private sector. The rational people would immediately infer that it will lead to an increase in money supply and inflation in the future.
High inflation would make them poorer if they do not take measures to protect them from the ill effects of inflation. Thus, they make higher expectations of inflation and incorporate that higher inflation into all new contracts they would sign, workers for wages and firms for outputs they deliver to customers. They also would invest in unproductive assets like land, real estates and gold to keep their wealth in a safer form.
This last action will create a bubble in the respective property markets and that bubble in no way contributes to an accelerated economic growth. Thus, the central would have doubled credit to private sector, but since it cannot fool people under rational expectations, it will not have a commensurate economic growth.
What it means is that since people are rational and form expectations rationally, neither authority can attain their policy targets by misleading them.
Sims and his Vector Autoregression
Since the freshwater economists base their analysis entirely on rational people making rational expectations, they are also called ‘rational expectations theorists’. While Sargent played a leading role in forming the rational expectations theory of macroeconomics with its other doyens like Robert Lucas and Neil Wallace, Sims concentrated in developing econometric and statistical techniques to assess policies and came up with the same conclusions which the rational expectations theorists had theorised.
His contribution was to use a new statistical technique called Vector Autoregression or simply VAR in short form, to assess policy impact without assuming any particular economic theory as the basis of the analysis. Thus even the opponents of the freshwater economics school or in other words who did not subscribe to the rational expectations theory of macroeconomics, could use Sims’ VAR technique in order to assess the impact of the policies of their choice on the major macroeconomic variables.
The Fiscal Theory of the Price Level
His contribution was to use a new statistical technique called Vector Autoregression or simply VAR in short form, to assess policy impact without assuming any particular economic theory as the basis of the analysis. Thus even the opponents of the freshwater economics school or in other words who did not subscribe to the rational expectations theory of macroeconomics, could use Sims’ VAR technique in order to assess the impact of the policies of their choice on the major macroeconomic variables.
The Fiscal Theory of the Price Level
Another major contribution of Sims is the radical theory he formulated in 1994 on the impact of government’s spending on inflation, called the Fiscal Theory of the Price level. Though there are scathing critics of this theory like Narayana Kocherlakota, Bennet McCallum and William Buiter, it has by far stood the test of time and deserves careful attention of policy makers.
The main proposition of the fiscal theory of the price level is as follows.
Government spending made to accelerate economic growth, irrespective of whether such spending is on day to day consumption or building up the economy’s capital stock, has to be financed re resorting to two ways: the government has to either borrow money or print money. If it borrows, it has to repay the same with interest on a future date. When it comes to repaying, it has three options to consider.
First, it can reissue the maturing Treasury bills and Treasury bonds and pay both the principal and interest. This is called refinancing or rolling over of public debt and its implication is that it increases the total borrowings of a government.
Second, it can generate a surplus in the revenue by keeping its consumption expenditure below the revenue and use that surplus to repay the principal and pay interest. This is called amortising of the public debt.
The third option is to create inflation in the economy by getting the central bank to print new money and reduce the real value of its debt. Then, though the government pays the same amount in nominal terms to those who hold governments’ Treasury bills and Treasury bonds, the real value of their savings become very much lower.
The historical experience is that almost all governments have resorted to the first and the third options in the past and it is very rarely they have resorted to the second option. So, the rational people, according to the freshwater economists, make a series of rational choices like the following: “Oh, the government has increased its expenditure and its implication is to raise further credit in the future to repay its loans. But it cannot borrow continuously and increase its total public debt.So, sooner or later, it has to print new money to repay the existing loans. It raises inflation in the future. That inflation makes us poorer by eating away our wealth. So, let’s get ready for this eventuality by consuming more today and thinking of only today and not of tomorrow. If we think of tomorrow, let’s think in terms of how we can make our wealth safer by converting it into forms that cannot be eaten away by inflation like real estates and gold.”
So, the government’s expenditure leads to an immediate increase in the demand for consumer goods creating an excess demand in the market. Though the government had expected people to produce more and fill that excess demand that does not happen because people, instead of investing in productive forms that would supply more goods to the market, put their moneys into unproductive forms of investments.
The result is obvious: an acceleration of the inflation rate. So, the governments have tried to fool the people by raising its expenditure levels by borrowing or printing money, but in the long run, it is the government which finds itself fooled by people. That is because, instead of attaining its objective of accelerated growth, it has now planted the seeds of permanent inflation in the economy.
Sims’ proposition is a revelation because up to that time, the belief was that it is only the money supply increases generated by central banks that would contribute to inflation. But now it is apparent that even without the central bank’s increasing its money supply, governments’ enhanced expenditures would lead to increases in the price level, because people would form higher inflation expectations assuming that the future inflation would be higher due to governments’ high expenditure in the current period. Economists have called this ‘policy ineffectiveness proposition’ which is true only if people are rational and make expectations on a rational basis.
Economists like Herbert Simon, Daniel Kahneman and Amos Tversky have come up with alternative forms of behaviour by the so-called Homo sapiens. That alternative form of behaviour has placed boundaries on their rational thinking and rational behaviour. Yet it is a proven fact that people cannot be fooled continuously and that particular behavioural trait is the one which necessary to prove Sargent and Sims correct.
So, if the two Nobel Laureates, Thomas Sargent and Christopher Sims, are taken seriously, governments should be beware of announcing bigger and bigger expenditure programmes to accelerate growth in their respective economies.
The main proposition of the fiscal theory of the price level is as follows.
Government spending made to accelerate economic growth, irrespective of whether such spending is on day to day consumption or building up the economy’s capital stock, has to be financed re resorting to two ways: the government has to either borrow money or print money. If it borrows, it has to repay the same with interest on a future date. When it comes to repaying, it has three options to consider.
First, it can reissue the maturing Treasury bills and Treasury bonds and pay both the principal and interest. This is called refinancing or rolling over of public debt and its implication is that it increases the total borrowings of a government.
Second, it can generate a surplus in the revenue by keeping its consumption expenditure below the revenue and use that surplus to repay the principal and pay interest. This is called amortising of the public debt.
The third option is to create inflation in the economy by getting the central bank to print new money and reduce the real value of its debt. Then, though the government pays the same amount in nominal terms to those who hold governments’ Treasury bills and Treasury bonds, the real value of their savings become very much lower.
The historical experience is that almost all governments have resorted to the first and the third options in the past and it is very rarely they have resorted to the second option. So, the rational people, according to the freshwater economists, make a series of rational choices like the following: “Oh, the government has increased its expenditure and its implication is to raise further credit in the future to repay its loans. But it cannot borrow continuously and increase its total public debt.So, sooner or later, it has to print new money to repay the existing loans. It raises inflation in the future. That inflation makes us poorer by eating away our wealth. So, let’s get ready for this eventuality by consuming more today and thinking of only today and not of tomorrow. If we think of tomorrow, let’s think in terms of how we can make our wealth safer by converting it into forms that cannot be eaten away by inflation like real estates and gold.”
So, the government’s expenditure leads to an immediate increase in the demand for consumer goods creating an excess demand in the market. Though the government had expected people to produce more and fill that excess demand that does not happen because people, instead of investing in productive forms that would supply more goods to the market, put their moneys into unproductive forms of investments.
The result is obvious: an acceleration of the inflation rate. So, the governments have tried to fool the people by raising its expenditure levels by borrowing or printing money, but in the long run, it is the government which finds itself fooled by people. That is because, instead of attaining its objective of accelerated growth, it has now planted the seeds of permanent inflation in the economy.
Sims’ proposition is a revelation because up to that time, the belief was that it is only the money supply increases generated by central banks that would contribute to inflation. But now it is apparent that even without the central bank’s increasing its money supply, governments’ enhanced expenditures would lead to increases in the price level, because people would form higher inflation expectations assuming that the future inflation would be higher due to governments’ high expenditure in the current period. Economists have called this ‘policy ineffectiveness proposition’ which is true only if people are rational and make expectations on a rational basis.
Economists like Herbert Simon, Daniel Kahneman and Amos Tversky have come up with alternative forms of behaviour by the so-called Homo sapiens. That alternative form of behaviour has placed boundaries on their rational thinking and rational behaviour. Yet it is a proven fact that people cannot be fooled continuously and that particular behavioural trait is the one which necessary to prove Sargent and Sims correct.
So, if the two Nobel Laureates, Thomas Sargent and Christopher Sims, are taken seriously, governments should be beware of announcing bigger and bigger expenditure programmes to accelerate growth in their respective economies.
(Wijewardena can be reached at waw1949@gmail.com)
