THE BLOG
10/19/2011 01:51 pm ET Updated Dec 19, 2011

Why Students Should Care About the Nobel Prize in Economics

Christopher Sims and Thomas Sargent won the Nobel Prize in Economics for research on measurement in macroeconomics. While some intellects might not follow The Dismal Science this year, this research has particular relevance for students today.

Sims and Sargent (working separately) created real tools to discern what happens when the government intervenes in the economy. (The answer: "It is complicated," if you wanted to skip ahead.) Intervening in the Land of Government usually means using either monetary or fiscal policy to give the economy a push -- forward, that is. Or at least that's the intention. In this economy, we need someone rubbing two sticks together in a dry room. Today's economy feels like a cold corpse. Government intervention can be needed to cool the economy, as well. When it is overly heated (growing too fast) that is, when inflation is raging, the cost of money needs to be raised to slow things down.

Many Americans are disciples of Adam Smith and his Invisible Hand, which purported that markets adjust on their own. The folks occupying Wall Street are not in this camp (but it isn't 100 percent clear exactly in which camp they are, other than the one with tents.)

Ever since The Great Depression, it has been generally believed that the government has a role in managing the economy and that it has a responsibility for getting America working and keeping America economically sound. After Roosevelt's policies during the Great Depression "created work," the American public came to believe that direct government intervention could be used to influence the economy.

Based on this Nobel Prize's research, it is unclear how much help the government can provide and whether its actions might actually hurt. The government is supposed to tame the two monsters of inflation and/or recession. Instead, it would appear that government is about friction.

Usually there are two types of intervention: monetary and fiscal policy. The President and Congress (should they be on speaking terms) usually determine fiscal policy. Proponents of fiscal policy believe the government can stimulate demand for goods and services. Tools of fiscal policy include raising or lowering taxes, increasing or decreasing regulation or spending money. The positive effect for those who like fiscal policy is that it can kickstart the economy. The net effect is that if the government lowers taxes or spends money and it doesn't lead to growth then a) the money has been wasted and b) it has probably led to greater budget deficits (or smaller budget surpluses, if you remember those halcyon days). For students of today, government spending in excess of taxes has to be paid by someone and that someone is probably you.

The alternative to fiscal policy is monetary policy. The Fed (not Congress or the President) holds the levers on monetary policy. It can put more money in circulation, buy bonds in the open market, or lower the discount rate (the rate banks borrow). Today's current monetary policy is to keep interest rates very, very, very low in the hopes that making it cheaper to invest will lead to, wait for it, more investment, more hiring, more jobs.

What is nice about the work of Sims and Sargent is that they applied real math to the analysis. Basically, they looked at how people (households, in econ terms) and firms (companies) adjusted behavior based on government policy. Giving credit to the common person, Sims and Sargent believed people would behave rationally given reasonable information. But this rational behavior was not always in sync with what government policymakers believed they would do. For instance, in a time of high inflation (which could be coming to a country we know soon) aggressive action could counter the expectations that prices levels would skyrocket. Their advice to our policymakers: For government action to be effective, it needs to be credible and long-term.