The Question That Won the Nobel: Can Government Really Fix the Economy?

Thomas J. Sargent of New York University and Christopher A. Sims of Princeton have won the 2011 Nobel Prize in Economic Sciences for their research on how government choices change the economy and how the economy changes government choices.

The Nobel committee announced that this year's award was all about the "cause and effect" of economic policies. In their words: "How are GDP and inflation affected by a temporary increase in the interest rate or a tax cut? What happens if a central bank makes a permanent change in its inflation target or a government modifies its objective for budgetary balance?" These are the questions that won Sargent and Sims the 2011 Nobel. Put more succinctly, the question at the heart of today's award is: What happens when government tries to fix the economy?

Sims' and Sargent's work focused on both fiscal policies (e.g.: greater spending) and monetary policies (e.g.: an interest-rate hike) in the short term and the long run. Theirs is a timely award, given the swirling debate about the economy, with one side saying more stimulus could trigger inflation and the other side saying no stimulus could doom the recovery.

Sims studied the impact of very specific shocks to an economy with a complex methodology called vector autoregression (VAR). This looks like a terrifyingly complex idea. (It is.) The best layperson summation I could find comes from Sims himself in an interview. He wanted a better model to show how a simple policy change, such as higher interest rates, might pinball its way through the economy, affecting prices and overall growth. Sims, himself:

VARs [are] the foundation of the way people think about monetary policy now as being based on interest rate adjustments and [their] effects on prices being slow and smooth, delayed for a year or so before they have their peak effects, and with a somewhat quicker but less long-lasting effect on real output.

As for Sargent, some of his best work dealt with the question of how monetary policy moves the economy. It's a big question. In the last few years, the Federal Reserve has successfully pulled down interest rates so that we are near historical lows in 10-year U.S. bond yields and mortgage rates. That should make it easier for government to borrow and families to buy homes. But look at what's happened. Austerity forces are putting limits on government borrowing (although our deficit is still quite high) and new homes sales are atrocious. One conclusion you could draw from this lesson is that monetary stimulus is most effective when it's paired with fiscal stimulus. Another is that in a balance sheet recession (i.e.: everybody starts the downturn with lots of debt to pay off and little demand for new couches and homes), monetary policy is fundamentally hamstrung.

Tyler Cowen, the George Mason economist and blogger, has cited Sargent's paper Some Unpleasant Monetarist Arithmetic as his "most valuable contribution" to the debate. The research posits, simply, that "good monetary policy requires good fiscal policy" in order to be credible. The paper was written in 1981, as Reagan and Volcker were fighting massive inflation, the opposite problem that the sluggish economy faces today. It suggested that tighter money could lead to higher inflation, even though inflation is normally associated with looser monetary policy.

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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