Did the U.S. government's decision to keep interest rates down lead to increased home buying in the United States in the middle of the last decade? Or did the boom in the housing market during those years result from people's expectations that the government would not raise interest rates? Sorting out such tangles of cause and effect in the world of macroeconomics is a messy business. But if you do it well, you might win a Nobel Prize in economics—as Christopher Sims and Thomas Sargent have done.
Sims is a professor at Princeton University; Sargent is a professor at New York University's (NYU's) Stern School of Business. They were once fellow graduate students at Harvard University and each earned a Ph.D. in 1968; later, they spent several years as colleagues at the University of Minnesota. But they did their award-winning work independently. Sargent and Sims will share the $1.5 million prize (formally known as the Royal Swedish Bank Prize in Economic Sciences) for their "empirical research on cause and effect in the macroeconomy," according to an announcement this morning from the Nobel Foundation.
Most causal relationships in the physical world are unambiguous: Push a ball and it moves. By contrast, the relationship between policy measures such as tax cuts and the health of the economy is often a two-way street. The reason is that individuals, businesses, and governments make decisions based on expectations of how other parties will behave in the future. For example, what companies expect policymakers to do can influence how much they invest in a new business venture. Similarly, when governments institute policy measures such as a tax increase, they are influenced by how they expect markets, investors, and consumers to react.
Both Sims and Sargent built on this idea of "rational expectations" to develop methods that help identify causal links between policy changes and economic events on the one hand, and macroeconomic indicators such as gross domestic product, inflation, and unemployment on the other.
Sims focused on how the economy is affected by short-term changes to economic policy and other events, such as an increase in the interest rate announced by a central bank or a spike in oil prices. Sargent helped understand how systematic changes in economic policy have led to long-term impacts. For instance, he studied how, in the decades following World War II, many countries implemented policies geared to promote inflation before changing to policies aimed at lowering inflation. Sargent's work showed how the public and banks adjusted to the change through a gradual learning process, explaining why it took a long time for inflation to come down.
Soon after the prize was announced, both laureates found themselves fielding questions about the lessons their research might hold for a world engulfed by a growing economic crisis. Both had a guarded response, refusing to be drawn into politics. "There is no simple answer; it requires a lot of slow work looking at the data," Sims told reporters, speaking by phone from his home in Princeton, New Jersey, during a press conference held in Stockholm to announce the prize. "The methods that I have used and that Tom has developed are central to finding our way out of this mess." In an interview with the Nobel Foundation, Sargent described himself and his co-winner thus: "We're just bookish types that look at numbers and try to figure out what's going on."
NYU economist David Backus says Sargent and Sims have had a profound influence on hundreds of students, many of whom the two laureates co-advised as faculty members at the University of Minnesota. Both are known for their devotion to mentoring, Backus says. Even today, their "lines of research are at the forefront of modern economics, something of a rarity when prizes are awarded for work done decades ago."
Sims was asleep when he got the call from Stockholm. The first time the phone rang, his wife couldn't find the "talk" button on the phone, so they went back to sleep, he told reporters. When he finally answered the phone and heard a Swedish accent on the other end of the line, he realized what was happening. "I was thinking, 'Well, maybe, it is the Nobel Prize,' " he says. Perhaps a rational expectation.