The Economics Nobel: From the esoteric to the practical

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was instituted in 1968 by the Swedish central bank, and laureates are selected by the Royal Swedish Academy of Sciences. It is commonly called the Nobel Prize in Economics, though the Nobel Endowment has nothing to do with it. It has mostly tended to go to scholars doing esoteric research in economics. Much of economic research has tended to be quite remote from influencing public policy. My professor at the Kennedy School of Government, Harvard University, Professor Thomas Schelling who taught me “game theory” used in nuclear strategy, and only sometimes in economics, got an Economics Nobel for just that in 2005. Now the trend from the esoteric and philosophical is moving towards the practical.

This year two American economists, William Nordhaus and Paul Romer, were awarded the Nobel Prize in Economics for their work in two diverse areas, but current concerns. Nordhaus won it for his warning policymakers during the first stirrings of concern about climate change in the 1970s that their economic models were not properly taking account of the impact of global warming and he is seen as one of the pioneers of environmental economics.

The co-winner – Romer – is seen as the prime mover behind the endogenous growth theory, “the notion that countries can improve their underlying performance if they concentrate on supply-side measures such as research and development, innovation and skills”. This simply means developing nations that want to get out of their rut, like India, must invest in quality education and R&D. Instead our bureaucratic centralism has created a huge system whose outcomes are so low grade, that mediocrity passes off as brilliance. The fact that Indian students and scholars have to go abroad to fully harness their brilliance and gain recognition tells us what has gone wrong with our system.

Paul Romer has argued, “Technological change can be accelerated by the targeted use of state interventions in areas such as R&D tax credits and patent regulation”. He called it “post colonial endogenous growth theory”. This famously inspired the an Oxford don, the economist Derek Morris, to write an odd to it. Its the history of economic theory in verse and is very witty and clever. The relevant verse for us is:

"Only inventions seemed to have any effect
And from where these arose everyone was quite bereft
So people then began to get rather weary
Of the once almighty neoclassical growth theory

A new explanation arrived,
over which there was quite a fuss
Technical progress – innovation, ideas – were "endogenous"

Invention was crucial but needed embodiment
In people – in skills – and in capital investment
So these were important to make growth shine
Although others had known this for a very long time."

But how does one nurture invention without a national mood? For it is now well understood that how we do as a nation depends a great deal on how we perceive ourselves? This psychological factor is now understood to be critical to sustained economic growth.

Classical economics was linked closely with psychology. Adam Smith’s other great work was “The Theory of Moral Sentiments” and dealt with the psychological principles of individual behavior. Smith emphasized the concept of empathy, the capacity to recognize feelings that are being experienced by another being. Jeremy Bentham described “utilitarianism as the greatest happiness of the greatest number that is the measure of right and wrong" and is considered by many as the father of the welfare state. Classical economic theory, also known as laissez faire, claims that leaving individuals to make free choices in a free market results in the best allocation of resources. Since individuals made choices the emphasis was on understanding human beings and their behavior as individual and as groups.

Neo-classical economists based their thinking on the assumptions that people have rational preferences; individuals maximize utility and firm’s profits; and people act independently. Consequently neo-classical economists distanced themselves from psychology and sought explanations for economic analysis heavily based on the concept of rational expectations. For most of the last century economics became increasingly mathematical. Much of economic theory came to be presented as mathematical models, mostly calculus, to clarify assumptions and implications.

It is not as if the switch was complete. Many great economists like Vilfredo Pareto, John Maynard Keynes and Joseph Schumpeter continued to base their analysis on psychological explanations.

In more recent times this school of economics has been given greater importance and is reflected in the award of Nobel Prizes to behavioral economists like Daniel Kahneman of Princeton University and last year to Richard Thaler. Making the announcement Nobel Committee said: "His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioral economics, which has had a profound impact on many areas of economic research and policy."

There is a delicious irony in the award of the Nobel to Richard H. Thaler. He works in the University of Chicago, the nursery of classical economics, where he is the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the Booth School of Business. Incidentally Raghuram Rajan who is also an economics professor is a colleague, was reported to also being considered for the Nobel for his “contributions illuminating the dimensions of decisions in corporate finance”.

The dominance of the classical school on the world of economics can be gauged by the fact that since the relatively recent inception of the Nobel Prize in Economics in 1968, the Chicago economics department faculty have won the Nobel as many as twelve times, twice as many as MIT, which has six Nobel laureates. Seen from Harvard University’s ivory tower even MIT is considered as leaning more towards classical economic theory. Recent Harvard winners for economics such as Oliver Hart (2016), Alvin Roth (2012) and Eric Maskin (2007) were rewarded for their work based on mathematical empiricism than behavioral speculation. Amartya Sen (1998) was one of the few who broke this mold and won it in recognition of his work and abiding interest in welfare economics.

Every politician worth his salt knows that national mood and perceptions are decisive in determining national outcomes. And often people do not always make rational choices, something that marketers of diverse products such as automobiles and soap, and political dreams know. But economists took their time recognizing this, and the Nobel Committee even longer. Better late than never.