Nobels Give Econometrics Pioneers Their Due

Thomas J. Sargent and Christopher A. Sims richly deserve the Nobel Memorial Prize in Economic Sciences they were awarded this week for their seminal work in the fields of macroeconomics and time series econometrics.

I was fortunate to have a front-row seat to observe the development of their path-breaking research. As a graduate student at the University of Minnesota in the 1970s, I was a research assistant for both: Sims became my adviser, and Sargent was a member of my dissertation committee. Since then, Sims, who now teaches at Princeton University, has had a major influence on my research, and Sargent, at New York University, has been my longtime collaborator.

The recovery from the recession of 2008-09 remains anemic. Job growth has stalled, unemployment stands above 9 percent, and there are renewed fears of another output drop.

A major factor behind the weak recovery and gloomy outlook is a climate of policy-induced economic uncertainty. An index we devised (see attached chart) shows U.S. policy uncertainty at historically high levels.

One of the benefits of being an academic economist is that market participants and government officials will often tell you what they think in relatively frank terms.

Here is what I learned in dozens of meetings last week in Frankfurt, Madrid and London:

We seem to be surrounded by “bubbles” -- tech stocks, real estate, and now maybe sovereign debt.

You might expect that any textbook would have a precise definition of this phenomenon; some set of characteristics that distinguish sensible high prices in good times from prices that are “too high” or in a “bubble.” Alas, “bubbles” seem to be in the eye of the beholder.

In recent weeks, euro bonds have gained traction in policy circles as the solution to the sovereign-debt crisis.

The proposed debt could be structured in different ways, but in all cases it would imply joint and severally issued obligations by the members of the euro zone and would fundamentally change the fiscal operations of the union.

The political response to the European crisis so far has been denial and temporary patches. But policy makers are facing more than just a liquidity crunch; they also need to tackle a solvency crisis and possibly a structural one. One of the most pressing issues is addressing the over-leverage of the southern European nations.

Economic theory tells us that in situations of over- leverage there are multiple equilibrium points. If all parties expect a sovereign borrower to be able to pay, the market will refinance that creditor at low rates, ensuring it won’t default. Conversely, if lenders expect a default, it will happen. The enormous volatility we are witnessing is the result of the impossibility of knowing which of these outcomes will prevail.

It is now believed that in the years preceding the recent financial turmoil, banks took excessive risks that weren’t disclosed, and regulators were only able to intervene after widespread panic had brought the system to its knees.

More transparency, it is argued, could have allowed the market to discipline such excessive risk-taking behavior. Yet there is evidence that, in many situations, greater disclosure may not be good corporate governance or even desirable.

Unemployment is high across the U.S., but some states are better than others at creating jobs. Texas Governor Rick Perry cast a spotlight on this when he entered the presidential race. His fast-growing state accounts for as much as half of all net U.S. jobs since mid-2009. Texas is part of a broader pattern, from which all states can learn.

Research shows that states keeping costs low for business have enjoyed better job growth during the past couple of decades. The low costs appear to be more important than other advantages often associated with higher spending, including infrastructure and an appealing quality of life.

Where do productivity gains come from? Economists have known for decades that the broadest measure of efficiency -- known as total factor productivity -- drives long-term income growth and prosperity. Progress occurs as firms figure out how to boost output without having to hire more workers or install more capital.

If total factor productivity sounds like something of a black box -- a quasi-magical ingredient that creates output out of seemingly nothing -- well, it sort of is. Sure, economists have some ideas about its sources: adoption of new technologies, better management practices, and improvements in production chains. But a more detailed understanding is emerging.

The Bureau of Labor Statistics reports that the time American workers spent at their paying jobs decreased by more than 8 percent between 2007 and 2010.

This sharp decline in aggregate market work hours occurred for two reasons: The unemployment rate  increased dramatically during this period, and the downturn reduced the average hours worked per week for those who were employed. It isn't surprising that the time people spend working in the labor market falls during recessions. But a close look at what individuals do with the lost work hours yields important insights into how they adjust to the hardships of a weak economy.