Thursday, November 17, 2011

Nobel Prize in Economics for 2011

The 2011 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded jointly to Thomas J. Sargent and Christopher A. Sims "for their empirical research on cause and effect in the macroeconomy."

Thomas Sargent is a professor at New York University in New York City and a senior fellow at the Hoover Institution at Stanford, California. Christopher Sims is a professor at Princeton University, New Jersey. Their research on the economy has investigated questions such as the effects of changes in interest rates, tax rates, and government borrowing. They create models that apply econometrics, the application of statistical analysis and quantitative techniques, to discover trends and to make forecasts.

Thomas Sargent uses structural macroeconometrics to analyze changes in economic policy. This involves an equation which discovers how the dependent variable is affected by the independent variables. The coefficients of the variables tell their economic significance, and the statistical significance tells how well that variable affects the dependent one. If there is much variation in an independent variable, then it will not predict the action of the independent variable. For example, if we examine the effect of education on income, the coefficient would be something like income going up by twice the amount of education expense, and this would have statistical significance only if most of the time, higher education would raise income, rather than often less education being correlated with more income.

Sargent also helped develop and apply the theory of rational expectations, by which people form expectations not just from recent events but also by analyzing the likely future changes in the economy and expected government policy. So for example, if people anticipate the expansion of money by government, that policy will not increase output, as prices and nominal interest rates will rise at that time, to prevent the erosion of income and wealth that would happen if the inflation were unexpected.

Christopher Sims developed vector autoregression techniques to analyze how the economy is affected by changes in economic policy and by shocks to the economy. A “regression” is a line trend that best fits some relationship such as between income and education. “Auto” means “self,” and an autoregression includes the results of previous dependent variables as new independent variables. For example, the value of a dollar today depends to a great extent on the value of a dollar yesterday. A “vector” is a set of numbers such as “1, 2, 3.” Vector autoregression (VAR) measures the interdependencies among several regressions. Each variable has an equation explaining its changes based on its own lags and the lags of all the other variables in the model.

The models developed by these two prize winners are used by the Federal Reserve and other central banks and other policy makers to analyze the effects of changes in tax and interest rates and other variables. Earlier simpler models failed to take into account the complicated relationships that are included in the models by Sargent and Sims.

A major principle of science is that correlation is not causation. When variable A is correlated with variable B, the data will not tell you which is cause and which is effect. It requires theory to determine this, and the techniques of Sims and Sargent apply theory to arrive at a cause-effect conclusion.

Sargent and Sims have done excellent work in generating conclusions from a mass of data. But basic economics can be understood with three very simple concepts. First, people respond to incentives, doing more when the cost is lower, less if the cost is higher. Second, the knowledge of how to produce is so spread out throughout the economy, much of it not written down, and often changing, that a government planner cannot possibly do better than the decentralized decisions of the local actors. Third, prices and quantities move towards equilibrium, meaning that profits induce more output, losses less output; a surplus reduces prices, while a shortage increases prices; all moving production and consumption towards harmony.

Thus the best policy is to let producers and consumers choose their action without interference from government. Get government revenue without increasing the cost of production and consumption, by tapping a resource that is not produced but already here, land, whose rent is a surplus beyond costs, and a free gift to humanity to use to pay for community services.

The work of Sargent and Sims is useful in determining the result when there are shocks to the economy, but really, it does not require statistical analysis to understand that taxation imposes an unnecessary shock. Tapping the rent for public revenue will have a transitional, temporary shock, which we can minimize by compensating for net losses, but forever after, it will allow people to invest, produce, and consume according to their own subjective desires.

My dream is that Sargent and Sims will apply their powerful techniques to analyze the effects of switching from today’s punitive tax system to an efficient system of public revenue from land rent, pollution charges, and voluntary user fees. History would then award these two economists with a prize much greater than that of the Sveriges Riksbank, the honor of having helped to achieve a lasting universal prosperity for humanity.



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