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A Nobel For Separating Cause And Effect

The Nobel in economics just went to Christopher Sims, of Princeton, and Thomas Sargent, of NYU.

The key work cited by the committee: Figuring out how economic policy affects the economy. This may sound simple, but it gets tricky because cause and effect are often tangled up with each other. The economy shifts, which in turn prompts, say, a change in interest rate policy, which in turn leads to more changes in the economy. So what is cause and what is effect?

Krugman says:

This is a statistical techniques prize — both men worked on methods for extracting insight from the data history provides us, which generally don't offer anything like a controlled experiment. ...before Sargent and Sims came along, econometrics consisted largely of estimating models you had no good reason to believe based on identifying assumptions (if you don't already know, you don't want to) that lacked credibility. S and S played a key role in developing methods that let the data speak instead.

The Nobel committee's explains the award-winning work:

How are GDP and inflation affected by a temporary increase in the interest rate or a tax cut? What happens if a central bank makes a permanent change in its inflation target or a government modifies its objective for budgetary balance? This year's laureates in economic sciences have developed methods for answering these and many of other questions.

The FT points out that Sargent is also associated with rational expectations theory, which has been called into question since the financial crisis:

Perhaps the main application of rational expectations theory is the efficient market hypothesis which asserts that the price of an asset contains all relevant information and cannot systematically be over-or under valued. It was the belief in this theory that led to the view that the credit bubble before the financial crisis did not exist.

For a response to this critique, see this in-depth interview in which Sargent discusses macroeconomics and the financial crisis.

For more: Tyler Cowen has lots of analysis and many more links. Here's his post on Sims; here's his post on Sargent.