The 2011 Economics Nobel - Christopher Sims

(Note : This was earlier written as part of the previous post, so it begins abruptly where that one leaves off. It got so long that I split the post into two. I am beginning to think that even very knowledgeable economists may have fundamentally mischaracterized Sims when they see him as someone primarily useful for empirical techniques)

I found Chris Sims much more exciting - digging into his work was a whole new level of education. This dude should really have been blogging! First of all there is the fact that his VAR, SVAR models and techniques require as few structural assumptions about the economy as needed. This I now believe is an important objection to all mainstream/blogosphere macro that tackles policy issues - why the need to presume unidirectional causality arguments? (If logical causality was to become the dominant paradigm in macro, shouldnt we all be Austrians by now?)

Indeed, Scott Sumner's critique of VAR as possibly misidentifying nominal shocks and reversing causality looks exactly wrong at first cut - that's precisely the kind of pitfall that VAR models seem to be trying to avoid. Second, and more importantly, Sims is almost wholly free of policy and worldview biases in the issues that he tackles. This is absolutely remarkable - almost unique - in a macroeconomist who writes most frequently on monetary issues. Lastly, Sims is about so much more than the empirical techniques! Reading even 2 or 3 of his papers is proof enough.

Here are a few gems I found in Sims's research:

1) Limits to inflation targeting - "Inflation targeting may do more harm than good if there is a substantial chance that the central bank cannot in fact control inflation. .........These considerations suggest that in those countries where inflation control has in the past been most difficult, inflation targeting may be least useful......."

2) Central banks are not really independent, sometimes not even monetary in countries with structural deficits

3) IS/LM critique (this one actually has several great sections worth reproducing in full)-

"Since the equations he wrote down did not include an explicit role for

expectations, the ISLM codification of Keynesian orthodoxy could plausibly ignore

them, and did so. This not only distorted Keynes’s thinking, it ironically weakened

Keynesian orthodoxy in the face of the rational expectations critique"

"A coherent Keynesian approach, accounting for endogenous expectations, implies very

strong effects of monetaryand fiscal policy and leads to greater attention to the

role of the government budget constraint in making the effects of monetary policy

conditional on prevailing fiscal responses, and vice versa"

"If money illusion, lack of foresight, and decision-making inertia are important

in macroeconomic dynamics, it seems more likely that they are important in labor

markets than in the majority (value-weighted) of investment and savings decisions"

"It is useful to recognize where we are introducing non-neutrality into a model and to bear in mind the limitations of non-neutrality assumptions. But it was one of Keynes’s central

insights that in this respect a little ad hockery is not too high a price to pay for

maintaining a model’s grip on reality"

"That an interest rate increase engineered by the central bank could exacerbate rather than reduce inflation, is commonly recognized in current policy discussions ... " (Is this mechanism at work in India these days?)

4) The price level in an open economy depends on the level of government debt

5) When does monetary policy determine the price level, when does fiscal policy. What to do at the zero lower bound.

6) Government bonds are like equity; TBTF bonds are almost like government bonds; Berkshire Hathaway is almost like a government

7) The biggest risks that the European Monetary Union faces : this one is beyond outstanding. It has so many great ideas that I can't even select properly. It describes most mechanisms at work in the Eurozone today, comprehensively. Oh, and it's written in 1999. Which makes it single best macro prediction I have encountered yet.

Phew, that's not a few, that's a lot. And there are many more. Chris Sims has basically tackled almost every major macro/monetary policy and theory conundrum head on in his career, and has outlined mechanisms that almost completely describe the macroeconomic funk (he does abstract out of finance and default) that developed economies find themselves in these days. He's done this about 10-15 years ago. He handles fiscal & monetary policy symmetrically, recognises the areas of overlap between the two, handles disequilibrium as well as rational expectations with equal ease, creates models that have monetary as well as fiscal non-neutralities, looks at open economy dynamics and explicitly recognises and models various deficit financing as well as budgetary constraint choices. Most importantly, he twists theories to suit facts.

And you're telling me that he is a VAR technician?

I feel almost obliged to link to an early 90's critique by Larry Summers of empirical macroeconomics, of exactly the kind of epitomised by Sargent & Sims. Summers is more appreciative of Sims's VAR models than of Sargent's 'deep parameter estimations'. I had enjoyed reading the piece earlier, agreeing with the basic philosophy though I had no real idea about the details. But I now think that Summers critique is basically summarized as 'empirical macroeconomics has not been useful yet' and I am less convinced. 'Yet' can be key. And as Noah Smith says here, the lack of conclusions from VAR models may be a feature not a bug. Could it be that the theoretical as well as 'pragmatic empirical' macro that Summers prefers pretends to tell us more than it really does?

I read one criticism somewhere that VARs are models with linear dynamics and as such may be unhelpful in describing the fundamental non-linearity of the macroeconomy. This sounds more reasonable to me. But then what do I know.

Either way, I found digging into Sims's work a mind-opening, nearly mind-bending endeavour. I invite everyone interested to do the same. You can begin with this interview here.

(Update : Have corrected some formatting/typo issues in this post as well as the previous one. )

The 2011 Economics Nobel

Thomas Sargent & Christopher Sims have received the 2011 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Tyler & Alex posted some excellent summaries (1, 2, 3, 4) over at Marginal Revolution. Others (Krugman, Sumner, Noah Smith) posted their own sets of congratulations, inferences & comments.

I'd heard of both but was until yesterday extremely unaware of the work of either, barring a faint memory of having read something (by Robert Hall, perhaps) about Sargent's place on the freshwater - saltwater spectrum and knowing the full expansions of VAR and SVAR. So yesterday was a day of great education. It is noted that this was a prize for 'empirical macroeconomics' or even 'macroeconomic empiricism'. Everyone also made amply clear that as true blue empiricists, both Sargent and Sims hold views and have published papers that sit uneasy with almost all ideological and policy camps. I found that the theory and policy implications, as well as the historical context, were often more revealing than the sophistication of the techniques, which I'm ill equipped to comment on.

Tyler linked to two of Sargent's most influential papers (1, 2). While the broad takeaway from both seems to be that monetary policy and fiscal policy must usually act together for either to be really effective in a business cycle, it was interesting that Scott Sumner linked approvingly to a paper titled "Some Unpleasant Monetarist Arithmetic" which claims that monetary authorities may be powerless in managing the price level and open market operations may end up achieving the reverse of what they intend to. On reading the paper, you understand why - Sargent's paper is about the importance of expectations in general and uses ratex (though he doesn't assert or necessitate that ratex is the right way to model expectations). Sargent also uses definitions of 'tight money' and 'easy money' that belong to a different era and that Scott has completely disavowed. But I still find it a little bit of a cheat that Scott doesn't mention the government debt mechanism for this counterintuitive result (more on this later), nor does he so much as nod to the later introduction that this result may hold even in the short run and thus monetary policy effectiveness is fundamentally contingent on accommodation by fiscal policy.

Tyler also linked to this interview with Sargent that I did not enjoy much - he defended the 'state of modern macro' by essentially saying that macro researchers are more nuanced than they are being given credit for. This is true but it is a truism. Almost every academic worth talking about is more nuanced than popularly characterized - this does not tackle the basic substance of the critique. I also found it a bit disappointing that Sargent didn't subject his hypothesis on the Eurozone (pages 10,11 of 14) to his own strict empirical standards, otherwise he would have easily noticed that the default risks are better correlated with the size and volatility of the capital account surplus than the fiscal deficits. One interesting bit was when he talks about the Kareken-Wallace model of banks and bank runs as an alternative to the more popular Diamond-Dybvig. He compares the basic features, assumptions and gaps in both models and I recommend reading that section (pages 5,6 of 14) in detail. Noah Smith's take on Sargent is charming and well worth reading - he calls Sargent a 'badass' whose research sometimes proved too hot to handle for theorists who would have wanted him to side with them. (The last link is a rather damning indictment of Lucas & Prescott if meant in all seriousness and not as an exaggeration).

Update : There was a part on Chris Sims written earlier for this post. But as I kept discovering more while writing it, I realised it deserved a separate post.