A Defense of the Nobel Prize Winners in Economics

A Defense of the Nobel Prize Winners in Economics


An economist friend told me that many in the profession find the laureates of the 2022 Nobel prize “sub-par”. I disagree. While I find the attempt of explaining panics and bank runs as the result of a rational calculation somewhat absurd, emphasizing the role of multiple equilibria (some clearly suboptimal) was extremely important and still not fully appreciated. Ways to avoid social systems (markets, economies) getting trapped in dysfunctional configurations is clearly of utmost relevance, specially in the current context.

The problem is that multiple equilibria within a rational expectation framework only scratches the surface of possibilities.

Moreover, suggests remedies that are not adapted when the real underlying effect is due to irrational expectations, mediated by social interactions that lead to self-sustained optimism or sudden confidence collapse. In other words, expectations can be subject to sudden, unexpected swings.

As often, the crucial importance of such effects became underlined long ago by Keynes. But Ben Bernanke was also aware of the disconnect between “real” causes and observed outcomes when he introduced his “small shocks, large business cycle” puzzle. Although confidence effects were not initially what he had in mind, his opinion changed during the 2008 crisis. In the book “Firefighting” (that I vividly recommend – for that book alone, IMHO, justifies his Nobel prize), he repeatedly insists on the role of confidence and irrational knee-jerk reactions. Here are some quotes:

“It felt safer to sell en masse than to try to figure out just how risky individual securities were.”

“Finance depends on confidence, and confidence is always fragile.”

And, concerning rational expectations:

“Our analyses focusing on the modest size and scope of subprime left out the unquantifiable variable of fear.”  

But if such confidence effects are so important, why are they totally absent from standard macroeconomic models?

As an attempt to weld together DSGE-like models and irrational confidence swings, we have proposed a multiple equilibria behavioural business cycle model that can account for demand or supply collapses due to abrupt drops in consumer confidence, which affect both consumption propensity and investment.

2109.09386.pdf (arxiv.org)

Our model suggests reasonable policy recommendations that prevent the economy from getting trapped in a low output, low investment and high unemployment equilibrium.

There is of course much more work that remains. But after reading the rather simplistic bank run model of Diamond & Dybvig that secured their Nobel prize. I feel one shouldn’t spurn somewhat unrealistic models, provided of course they capture the right underlying mechanisms.

Written by Jean-Philippe Bouchaud

A Defense of the Nobel Prize Winners in Economics