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An economics Nobel Prize for examining reality

epa05579836 Massachusetts Institute of Technology (MIT) professor Bengt Holmstrom who has been awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel speaks at a press conference at MIT in Cambridge, Massachusetts, USA, 10 October 2016. Holmstrom and Oliver Hart of Harvard University were awarded 'for their contributions to contract theory'.  EPA/CJ GUNTHER


This year’s economics Nobel Prize has gone to Oliver Hart and Bengt Holmström, for their work on the theory of contracts. For good primers on the winners and their work, check out the blog of economist Kevin Bryan, several posts by the always-reliable Marginal Revolution, and the summary written by Bloomberg View’s Tyler Cowen.
The research here is deep microeconomic stuff. It’s about incentives, and imperfect information, and long-term relationships. It’s about delicate strategic interactions between people who don’t know each other’s capabilities or intentions. But it’s related to lots of real-world economic issues — performance pay, mergers and acquisitions, bank lending and corporate
What it’s not about is the kind of economics you read about in the news. It’s not about growth or unemployment, fiscal stimulus or interest rates, trade agreements or productivity. It might be indirectly related to those things — Holmström’s work on financial crises and debt certainly has relevance for what happened in 2008. But it isn’t what you expect to see economists arguing about when you open up Bloomberg or pick up the New York Times.
It’s not macroeconomics — the study of how the broad economy works.
That’s interesting, because in the past, the Nobel went almost exclusively to macro research. In the decade after the prize was created by the Bank of Sweden in 1969, nine out of 10 prizes went to things that we would call “macro.” In the 1980s, it was about half.
Nowadays, prizes for macro research are less dominant. The last true macro prize was in 2011, for the empirical work of Christopher Sims and Thomas Sargent. Other macro prizes came in 2010, 2006, and 2004. The prizes in 2013 for financial economics and 2008 for the economics of trade and geography have some macro flavor — after all, trade and finance both affect business cycles and growth — but both are now considered distinct fields, with their own distinct methods and data sources.
Meanwhile, the number of prizes in fields like game theory is on the rise. This year’s winners do work that’s somewhat similar to that of 2014 winner, Jean Tirole, who studied corporations. Micro theorists also won prizes in 2012, 2007 and 2005. Though this is a small sample to work with, it does seem as if micro theory’s star is on the rise within the profession.
What should we make of this development? Economics debates in the news media and on the blogs tend to make a big distinction between macro and micro, painting the former as unscientific and the latter as serious science. There’s a grain of truth to that, but it’s not that simple.
What really happened was that macro developed first. Economists saw big, important phenomena like growth, recessions and poverty happening around them, and they wrote down simple theories to explain what they saw. The theories started out literary, and became more mathematical and formal as time went on. But they had a few big things in common. They assumed the people and the companies in the economy were each very tiny and insignificant, like particles in a chemical solution. And they typically assumed that everyone follows very simple rules — companies maximize profits, consumers maximize the utility they get from consuming things. Pour all of these tiny simple companies and people into a test tube called “the market,” shake them up, and poof — an economy pops out.
Even today’s macro theories are similar in spirit. Most of what you see in academic seminars or at central banks are so-called general-equilibrium models.
But in the meantime, economic theorists have been branching out in different directions. They began to think much more seriously and deeply about how people and companies behave and interact. And those efforts are paying off with real-world applications — Google’s auctions, kidney transplants, or government sales of wireless spectrum rights are a few of the better-known examples, but there are more all the time. And theories like those of Hart and Holmström are changing the way companies think about everyday economic issues like performance pay and mergers and acquisitions. Meanwhile, most of the explosion in empirical work is in micro fields, if only because those have much more copious and reliable data.
So economics, as a science, is sort of an odd bird. Most fields start small and then get large. First, chemists and physicists figured out how things work in the laboratory, and only later did they move on to predicting the effects of things like climate change. Econ, though, started out making big bold predictions about recessions and growth, and only later moved down into the laboratory and donned smocks and goggles.
I think it would be wrong to interpret the shift toward micro-focused Nobels as a rebuke to macro. Instead, it’s more about the new exciting tools that have been developed in the micro world. Think of macro as like a space program — a spectacular effort that got lots of headlines and news coverage, but whose scientific value is still being debated. And think of micro as the useful but humble spinoffs from that program. One is the glamour division, and the other is the real engineering.

epa05579476 British-born Harvard Economics Professor Oliver Hart who has been awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel along with MIT Professor Bengt Holmstrom (not pictured), sits at his home in Lexington, Massachusetts, USA, 10 October 2016.. The two were awarded 'for their contributions to contract theory', the Committee for the Prize in Economic Sciences in Memory of Alfred Nobel and the Royal Swedish Academy of Sciences in Stockholm, Sweden announced on 10 October 2016.  EPA/CJ GUNTHER

— Bloomberg

Noah Smith copy

Noah Smith is a Bloomberg View columnist. He was an
assistant professor of finance at Stony Brook University, and he blogs at Noahpinion

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