Profs find tools to examine cause and effect

A recent newspaper essay on the joys of walking around Paris, even in the rain, recounted how the author ended up paying more than $200 for an umbrella. The writer harbored no regrets for what was a thoroughly enjoyable transaction that introduced him to a sphere of high quality in the market for what most people consider a low-cost commodity item.

The umbrella story illustrates two important aspects of economics. The first is that consumer choices are affected by a variety of factors. The usual explanation of price-driven supply and demand is far too simplistic to cover the complex world we live in.

Consumers, businesses and markets are affected profoundly by timing, expectations, institutions and structural changes in an economy.

The fundamental concept that lower prices increase the quantity demanded and higher prices reduce them is good enough to get us started in our understanding of economics. But most often it isn’t enough to predict or explain what is going on. Its limitations, though, might explain why our economic forecasts are often so wrong. This is interesting stuff for academics but for most of the world it seems pretty unimportant, until it turns out to be very important. And that’s what this year’s Nobel Prize in economics is all about.

The Sveriges Rikksbank in Sweden awarded this year’s Nobel Prize in economics to two Americans, Thomas Sargent and Christopher Sims, two self-effacing professors whose work on macroeconomics is in active use by economic policy makers worldwide.

There is a special luster to the prize when it goes to people who have such a deep affection for economics. The two professors — Sargent at New York University and Sims at Princeton — clearly love their chosen field and that attraction has energized and informed their life’s work.

Both economists are welcome throwbacks to an earlier, more productive, time in economic thought. Although their work is cutting-edge in the sense of its complex statistical analysis, their contributions are firmly rooted in fundamental, even old-fashioned, economics.

Despite the fact that they are friends, have worked together, share similar academic backgrounds, and even teach a graduate course together at Princeton, their approaches to the economic problem are very different — and illustrate a significant issue in economics: causality.

The problem of cause-and-effect — and identifying which was which — popped up the very first time an economist tried to put real numbers into a demand curve. It turned out that it was very difficult to tell whether the changes in price recorded in the data were the result of changes in demand or changes in supply.

The world of data is very different from the world that most of us, even economists, live in. The difference is as dramatic as the world under the sea compared with the world on the earth’s surface.

Economic policy makers, though, urgently needed to navigate through the data to shape effective actions. This is especially true of monetary policy, where central banks need to know not just what is likely to happen but when and for how long.

Sargent and Sims developed the mathematical tools, the statistical sonar system that allows economic policy makers to navigate and explore the world of data.

On one level it wouldn’t be wrong to describe their different approaches as recalling “Mr. Inside and Mr. Outside,” the legendary ‘Doc’ Blanchard and Glen Davis of Army football fame. Professor Sargent explored the long run causes and effects, as well as the interactions of policies and structural changes in the economy. Professor Sims, on the other hand, concentrated on the more immediate effects of both policy-driven changes and unexpected shocks to an economy.

On another level, their approaches echoed a still unresolved controversy in economics that dates back to the late nineteenth century: the relationship between data and economic theory. One group believed that without a theory data was just meaningless information and the other believed that theories could emerge from examination of the data itself. Over time the wisdom embedded in both beliefs softened the controversy and produced an armistice, but there never has been a clear resolution of the issue.

Professors Sargent and Sims took two different approaches to the data that in many ways reflected the original controversy. Professor Sargent analyzed the data to test theories and Professor Sims analyzed the data to deduce causalities and produce theories he later tested. Developing powerful statistical tools as they needed them, their complementary work was a major advance for economics.

The Nobel Prize is a recognition of their individual achievements and an appreciation of the value of their work, not just to those who love economics but also to millions of people whose prosperity, and sometimes survival, depends on sound economic policies.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.