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Monday, October 14, 2019

Nobel Prize: A New Dawn for Old Economics?

For the first time in forever the Swedish Nobel Memorial Prize Committee in Economics actually got it right. This year's prize is a strong argument for school choice, free-market health care... and more.


Normally, the Nobel Memorial Prize in Economics is not of much relevance to the world outside of dusty academic hallways. For one, the prize itself is not even a real Nobel Prize - it was created in 1969 by the Swedish Central Bank in memory of Alfred Nobel - which renders it a lower status than the prizes in physics, medicine and chemistry. (The prizes in literature and peace went political haywire a long time ago...) However, this year's prize is actually interesting to a broader audience, for two reasons: its methodology and its possible implications for welfare-state reform.

These two reasons are intertwined, with the methodology in the lead. Here is how the Prize Committee motivates this year's Laureates:
Despite massive progress in the past few decades, global poverty - in all its different dimensions - remains a broad and entrenched problem. For example, more than 700 million people subsist on extremely low incomes. Every year, five million children under five die of diseases that often could have been prevented or teated by a handful of proven interventions. Today, a large majority of children in low- and middle-income countries attend primary school, but many of them leave school lacking proficiency in reading, writing and mathematics. How to effectively reduce global poverty remains one of humankind's most pressing questions. ... This year's Prize in Economic Sciences rewards the experimental approach that has transformed development economics, a field that studies the causes of global poverty and how to best combat it. In just two decades, the pioneering work by this year's Laureates has turned development economics ... into a blossoming, largely experimental field. 
The methodology that is being rewarded, which is a good one, consists of two steps. In the first, the scientist comes as close as possible to the object of study, asks questions about the object that are as unbiased as possible, then - if possible - aggregates the knowledge obtained upward into macro-level conclusions. In the second step, the scientist creates experiments where changes are made to the object of study in order to verify or falsify the theory generalized from the initial observations.

There is not as much involvement of established, model-based research in this line of research as in traditional economics. Normally, the methodology decides what questions economists can ask: if the question doesn't fit a linear-regression model, it is not worth asking. This has been the predominant - not to say dominant - methodology in economics since about when New Classical Macroeconomics emerged 40 years ago. It has zoomed economics research in on a narrow path of rather unimportant issues. 

Some branches of economics have remained true to the more general form of methodology that social sciences have worked with for at least two centuries. Economic psychology and game theory are two examples where both parts of this now-Nobelized methodology has prevailed. The first part, inducing theories from observations, has more widespread support. Two of my favorite references here are:

Kahneman, Knetsch and Thaler: Fairness as a constraint on profit seeking; American Economic Review 4/1986;
Bewley, T: Why Wages Don't Fall During A Recession; Harvard, 2000.

I used their methodology in my own dissertation as part of an investigation of people's perception of uncertainty and price stability:

Larson, S R: Uncertainty, Macroeconomic Stability and the Welfare State; Ashgate, 2002. 

The problem - so to speak - with this methodology is that it puts established theory on its toes. In my own case, I proved that Walrasian economic price theory, in its policy implications, was invalid. This is a big conclusion to draw, and attracted derision and ire from established scholars... Nevertheless, the other two references above contributed similar evidence, and so has a large body of research both earlier and later. 

As Thomas Kuhn so elegantly explained in his Structure of Scientific Revolutions, when an established paradigm is upset, it tries very hard to defend its position as the definiens of scholarly problems. This year's Nobel Memorial Prize rewards a challenge to a paradigm that has shaped economics - from the literature to the classroom - for four decades. It will take a while before this new methodology works its way outside the realm where it is now established, namely development economics, but once it creeps into other areas, the consequences for economics as a discipline will be significant. 

Which brings us to the welfare-state reform side of the issue. Today, it is practically impossible to find any economic research on systemic reforms to the role of government. At the same time, there is mounting evidence that government is indeed a systemic problem for the economy as a whole. We have seen a long, slow decline in GDP growth across the Western world, a trend that has been ongoing for at least 20 years, in some cases since the 1980s. This systemic phenomenon has a systemic cause, and the only candidate is the welfare state. 

Mainstream economics has refused to acknowledge this, in part because of the dominant methodology. You cannot fit the kind of variables needed for such research, into either linear or non-linear regressions; uncertainty, by definition, does not fit inside the quantitative confinements of econometrics. 

Again, it remains to be seen where this Nobel Memorial Prize award will take economics, but at least there is some light in the tunnel.

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