The Nobel Series : Economics & public policy

As we know, the Nobel Prize in sciences (physics, chemistry and medicine), literature and peace began to be awarded in 1901. In 1969, the Bank of Sweden, in its tercentenary, made a donation to the Royal Swedish Academy for the institution of the award in economic sciences. In this series of articles, we will briefly overview the work for which various social scientists were awarded the Nobel Prize in economics and see how it has impacted actual policy decisions worldwide. In this article, we will give an introduction to the Nobel prize and various views expressed about the prize. We will also cover the state of the economics discipline vis-à-vis the Nobel Prize.

Nobel Prize in Economics

While there is not much difference between the Nobel Prize in other areas and economics, some say it is not the same. On one hand, the winner attends the same ceremony, receives a diploma and a gold medal from the Swedish monarch, and gets the same cash prize. But on the other hand, the non-economic prizes were constituted by Alfred Nobel himself to recognise accomplishments that had "conferred the greatest benefits to mankind". As noted above, the Prize in Economics was set up by the Bank of Sweden (Sveriges Riksbank in Swedish). Some claim that the intent not only different but required no obligation to consider "benefits to mankind".

The Nobel Prize in Economic remains the most coveted award in the social sciences. Not only does it bring a cash prize, but it also catapults the winners to the top of the league in the economics/social science discipline. This does not mean that the choice of awardees by the Academy is not criticised. This criticism often comes from other economists and social scientists. To be sure, the economics discipline has also been under the lens from within and from outside academics and policy specialists. The most common criticism from within economics is that most research is of little value in policymaking and even less so in the real world. For example, the Arrow-Debreu framework of general equilibrium has been criticised on the grounds that it is abstract, too mathematical and makes too many unrealistic assumptions. Indeed, this is the criticism of the neoclassical framework also. The response from the mainstream economists has been to do more of the same since the models are elegant, and largely true, given the assumptions. They are also falsifiable, an important trait of scientific research. On the other hand, many economists have relaxed many of the assumptions of the neoclassical model and taken it closer to the real world. For example, economists from the New Institutional Economics school have relaxed the assumptions of zero transaction costs, perfect and symmetric information, rationality and incorporated variables such as property rights to better explain and inform public policy.

Another vehement critic of the economics discipline in general and the Nobel prize, in particular, is Nassim Taleb, the celebrated author of The Black Swan. In this book, Taleb has criticised the research methods used in economics. He has suggested that the bell curve (or the normal distribution), which is the basic assumption in most economics research is simply untrue and therefore leads to faulty predictions. According to him, most real-world economic variables don't always follow the normal distribution and if one injects a higher level of uncertainty, most economic models break down. Writing in the New York Times on January 16, 2014, he states:

The good news is that those models that miss rare events also break down when one introduces a higher layer of uncertainty into them, called "parameter uncertainty". This gives us a fault detection mechanism. What goes out of the window? The entire discipline of modern finance and portfolio theory (the theories named after Harry Markowitz, William Sharpe, Merton Miller), the model-based methods of Paul Samuelson, much of time series econometrics (which don't appear to predict anything), along with papers and theories that are based on "optimization." These bring fragility into the system. So, simply, we would have great jumps in knowledge if we avoided teaching these models, and replaced them with anything, even gardening classes.

Later, Taleb was also caustic in his criticism of Robert Merton and Myron Scholes, who are known for Black-Scholes-Merton formula for the pricing of options. Merton and Scholes also jointly received the Nobel Prize in 1997 for their model of valuing derivatives that is designed to hedge against risk. Taleb says that their model is based on fictional mathematics and blames them for not predicting the failure of the Long Term Capital Management (LTCM) in 1998. In fact, they had claimed that the probability of LTCM failing was one in a trillion. We all know that LTCM, a hedge fund in the USA failed because of their over-leveraged trading practices (a repeat of which we saw in the run-up to the 2008 financial crisis) and had to be rescued by the US Government. The Board of Directors of LTCM also included Merton and Scholes.

Taleb has also been less than charitable about the Nobel Prize in Economics. He has gone so far as to suggest that investors who lost money in the financial crisis should sue the Swedish Central Bank for awarding the Nobel Prize to economists whose theories he said brought down the global economy. He was referring to the Nobel awarded to Markowitz, Miller and Sharpe in 1990 for their work on portfolio theory and asset pricing models.

The state of economics as a discipline has come in for criticism from within too, particularly for its failure to call out practices such as sub-prime lending and faulty credit ratings in the run-up to the financial crisis of 2008 and failing to predict the 2008 crisis itself. Apart from a few cautionary voices such as that of Raghuram Rajan, Nouriel Roubini and Nicholas Taleb, hardly any economist saw the 2008 crisis coming. Even before the 2008 crisis, there were voices that economics seemed more and more like mathematics and in the pursuit of making economics a 'hard' science in the mould of physics, economists were forgetting the 'economics' in their models.

The other criticism of economists has come from other social scientists. While some have questioned the 'imperial' or expansionist nature of economics, whereby neoclassical models are applied without careful thought to political and sociological problems, others have questioned the assumptions of the neoclassical model. As mentioned above, New Institutional Economics has grown as a discipline within economics by relaxing the assumptions of neoclassical economics, but it has not really supplanted the latter. On the other hand, behavioural psychologists such as Herbert Simon, Kahneman, Tversky and others have questioned the validity of the neoclassical model by questioning rational choice theory on which the neoclassical model is founded.

In defence of the Nobel Prize & economics

While the above critiques of the Nobel Prize and economics as a discipline have some merit, some have gone too far. Economics continues to provide sound inputs into public policy, whether it be taxation, environmental issues or world trade. Taleb has a point that economists' models, particularly the neoclassical model where there is an over-reliance on the efficiency of the market, fail to foresee 'black swans'. However, Taleb's criticism is largely about the failure of the models to 'predict' events and mainly targeted at the financial sector. We know that the same models do a decent job of suggesting sound policies in areas such as international trade, pricing scarce resources, tax reform, growth and development, etc. Keynes general theory not only accurately described the causes of the Great Depression but also suggested possible solutions that guide us to this day. Tools of microeconomics, which have been refined over the years are useful in analysing basic issues such as supply and demand, market equilibrium, pricing etc.

Not only that, there have been efforts from within the economics discipline to address the unrealistic assumptions as we have seen above. The New Institutional Economics (NIE) has been helpful in addressing policy issues in a number of areas such as public goods, climate change, environment, education, health and taxation. Behavioural economics and experimental economics have moved away from the neoclassical model and addressed issues such as loss aversion (which basically says that losses loom larger than gains and is a part of prospect theory, which contrasts with the rational choice theory), economic growth, unemployment and poverty eradication.

The Nobel Prizes awarded in the recent past have mirrored this 'reform' from within. The Prize was awarded in 2002 to Daniel Kahneman for his work in applying psychological insights to economic theory, particularly in the areas of judgment and decision-making under uncertainty. It is interesting to note that Kahneman is a psychologist, applying his tools to an individual's behaviour. Again, one of the Nobel Prize winners in 2009 was Elinor Ostrom who is known for her work on overcoming collective action dilemmas through cooperative methods of governance. Ostrom was also a non-economist. Many economists from the NIE school have been awarded the Nobel Prize reflecting this willingness to address some of the assumptions of the neoclassical model that straitjackets the discipline and prevents it from addressing real-world economic problems. Some of the economists include Douglass North in 1993, Ronald Coase in1991, Oliver Williamson in 2009, Thaler in 2017 etc.

Conclusion

In this series of articles, we will look at the Nobel Prize winners over the years and the application of their work to public policy. Ever since the first Sveriges Riksbank Prize in Economic Sciences (or the Nobel Prize in Economics) was first awarded in 1969 to Ragnar Frisch and Jan Tinbergen, there have been many changes in the economics discipline. Frisch and Tinbergen, of course, won the Prize for their work on econometrics. Frisch coined the term 'Econometrics', founded the Econometrics Society and edited the associated journal 'Econometrica' for 22 years. Tinbergen, on the other hand, was more involved in applying econometric tools to policy. One of his seminal contributions was a macro-econometric model of the US economy, which he presented in the 1930s. We will discuss more of their work in the coming essays.

Until about the early 1970s, Keynesian economics held sway in government policy, i.e. government expenditure can be a tool of fiscal policy to raise output. This view was challenged by the monetarists, who hold that controlling the supply of money would control inflation, interest rates and ultimately output. According to monetarists, government expenditure only causes inflation and crowds out other investment. Similarly, in microeconomics, the 'Marginal Revolution' of the late 19th century, to the work of Pigou and Coase on externalities and that of Samuelson on mathematical modelling of public goods are some works that are still relevant. Many of these works were awarded the Nobel Prize while others missed the bus.

Views expressed are personal