The Nobel Prize in Economics for 2011 has been given to Thomas Sargent and Christopher Sims for their work on how central bank policy shapes an economy dynamically. There’s always a bit of politics in this Nobel Prize, and this year is no different. The two recipients more or less proved that economics can be used for a central bank, and even a government, to shape the future. Expectations guide how people make decisions, and they aren’t always rational.
If that sounds obvious, it’s partly because we’re living in a world that these two helped define. It helps to take a step back to a time when economics was inherently backward looking, going over old data as it comes out and adjusting to meet the world that was measured a month or several ago.
In the early 1970s central banks found themselves unable to do their jobs. The postwar economy had been built on the foundation of a stable US Dollar backed by gold that was the standard for the whole world. By 1968, however, things had started to change in ways that were not anticipated. The US was no longer the exporting monster it had been when the system was set up and the value of the buck was slipping. Nixon eventually abandoned the Gold Standard and let the currency float to whatever value it would trade at.
Oil producing nations, in part responding to being cut from the loop, took action and jacked up their prices with a cartel. The resulting inflation was devastating and completely out of control. What was the Federal Reserve supposed to do?
Sargent argued during this time that the expectation of inflation helped to fuel more inflation because people planned for it to be a part of their world. Getting it under control was a matter of shocking the system so that people came to understand that policy was going to tame inflation one way or the other – and then waiting a couple of years for this to sink in.
It worked, although the recession of 1980 was caused in part by the rise in interest rates that was necessary to make it happen.
Ever since this time central banks have made expectations central to their policies. This may seem obvious to us today but we can only say that because the work was universally adopted. What’s more interesting is that where traditional economics relies on rational decision making, this work makes no such claim. People act on what they believe will happen whether it’s based firmly in reality or not.
On the other hand, and there’s always another had in economics, expectations shape policies because what people think is going to happen has a tendency to be a self-fulfilling prophesy unless someone steps in to change it. The result is that central banks, along with governments, always find themselves in a discussion about our future.
Back to the politics of the announcement. Sargent, in particular, has long been a candidate for the prize based on his work so there wasn’t a big surprise. But at a time when central banks and governments around the world are having trouble making decisions, and Europe in particular has done little but delay making their big call, highlighting this work makes a definitive statement. Leadership matters, and big problems call for big actions.
The prize itself is not likely to influence how leadership acts, of course. It’s more of a shot across the bow than anything as pressing as the collapse of the Greek economy. But it’s an argument that activist government – and central banking – shapes the way we live. If things are not going well it’s because the right actions are not being taken. If that sounds like a big “Duh!” then welcome to the world of economics.
What matters most is that this depression has not been handled like the previous ones largely because of the work cited in the Nobel Prize. The ability to have a Managed Depression, where the psychology is kept on an even keel even as the economy storms and swells around us, is based on this work. Stay tuned to find out how well it comes out in the end – outside of 10 million Swedish Krona in immediate economic stimulus for two deserving guys, that is.