Capitalisn’t: Predicting This Year’s Nobel Prize in Economics

Luigi: So, we’re finally in October, and most people think this is a spooky month because of Halloween, but for all the leading economists, this is a spooky month for a different reason.

Kate: What reason would that be, Luigi?

Luigi: They are really getting frantic about the possibility of winning the Nobel Prize, or even worse, that some of their academic rivals might win it instead of them.

Kate: The horror!

Speaker 3: It is a great honor to introduce the laureate of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.

Luigi: This year, the Nobel Prize in Economics will be announced on October 14th, just a week away from this episode.

Kate: So, speaking of people getting nervous; are you nervous, Luigi?

Luigi: No, because number one, I’m not old.

Kate: Uh, debatable.

Luigi: But most importantly, because I’m not in the running.

Kate: How do you know that you’re not in the running, though?

Luigi: Oh, it’s very easy to get a sense of who is in the league and who is not. And so, in today’s episode, we are going to take a break from talking about capitalists, and we’re going to talk about the Nobel Prize in Economics. How do you win it, why is it important, and how do you make predictions about who might win it or not?

Kate: From Georgetown University, this is Kate Waldock.

Luigi: And from the University of Chicago, this is Luigi Zingales.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Let’s start with clarifying one important point: in the pecking order of Nobel Prizes, the Nobel Prize in Economics is a distant relative.

Kate: It’s not even a real Nobel Prize, to be honest.

Luigi: It is not a real Nobel Prize. The correct name is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. It was not instituted by Nobel himself, it was instituted by the central bank of Sweden in 1968.

Kate: If you’re a hard scientist, like a physicist, you might win the Nobel Prize for a major discovery, like the discovery of the transistor. And for something like biology, you might get a Nobel Prize for figuring out the structure of DNA.

Luigi: And the question is, how and why do you win a Nobel Prize in Economics? And to explain most of the Nobel Prize in Economics, I think it’s useful to use a classification that a famous philosopher, Isaiah Berlin, used once between hedgehogs and foxes.

Kate: Is that because hedgehogs are spiky and foxes are soft? I mean, does this have to do with the relative cuteness of these two animals?

Luigi: Uh, no. It has to do with a lyric of an ancient Greek poet that said that foxes know many things, the hedgehog only one, but big. And so, there are some economists who are about one big idea, and basically, they won the Nobel Prize for that contribution. And then there are others that are kind of all over the place. They contributed so much in so many areas, but they’re not identified with one big, single idea.

Kate: Whom might we put in the hedgehogs category? I think one example might be someone like George Akerlof, and he’s known for his work on lemons.

George Akerlof: My paper, “The Market for Lemons,” explored how markets with asymmetric information operate. For example, the buyer of the used car fears that she will be stuck with a lemon. The seller of used cars sees how little she will pay for one and therefore will not supply a good-quality car. Because of this interplay of concerns, markets that should exist, collapse. The best example is the market for health insurance for the elderly.

Luigi: And in the other category, the fox category, we have Jean Tirole. Actually, his two most-cited papers are his books, one book on industrial organization and the other book on regulation and procurement. And both these books kind of close a field rather than open a field. And why do they close a field? Because they were so comprehensive, and they expose all the nuances, that it was very difficult to keep doing what people used to do before, after those books.

Jean Tirole: Well, my work which has been awarded the prize is on the regulation of industries. The regulation of industries includes what we call antitrust, which means that the judges and courts and antitrust authorities check the behavior of large firms to check there is no abuse of dominant positions so that large firms don’t abuse their power. It also includes regulation of what’s called network industries, so the telecom industry, electricity industry, railroad, post offices, and also a little bit the regulation of banks, which of course has been a very topical issue lately.

Kate: Luigi, do you think there’s been any trend recently in whether the Nobel Prize committee is going more in the direction of hedgehogs or more in the direction of foxes?

Luigi: I think that actually we started to introduce the fox category relatively recently. In the past, people really won the Nobel Prize for one very specific contribution. And I think in recent years we have seen Jean Tirole, or even my colleague Gene Fama, as being incredibly influential across the entire financial economics field. But I think that the Nobel committee seems now more open to give prizes to people who have massively contributed to the field.

Kate: OK. So, it seems like the Nobel committee is becoming a little more open-minded about giving prizes to broad thinkers, but there’s a much more specific criterion that’s important for the Nobel Prize committee, and what would that be, Luigi?

Luigi: So, if you look at the statement of the Nobel Prize, they want somebody that not only has contributed greatly to the field, but also with some contribution that has some practical application.

But in practice, if you want to try to predict who’s going to get the Nobel Prize, I think that the first thing that you want to see is whether they are well cited in the economic literature. More than 10 years ago, I wrote a paper about the articles that had more than 500 citations at the time. This was in 2005. There were only 11 authors who had at least three papers in that group. Of these 11 authors, seven since then got the Nobel Prize, and one of them unfortunately died. So, basically, in this restricted group of 11, there are only three that have not received the Nobel Prize yet.

Kate: So, who are those three that didn’t get the Nobel Prize?

Luigi: So, one is Robert Barro, and the other is Mike Jensen, and the third one is David Kreps. Robert Barro is a very good example of a fox. Barro’s research spans across many different aspects of macro. One of the most important is his research on economic growth, and in particular convergence across countries. He tested whether it is true that richer countries grow less. And so, we can hope to have a convergence of poorer countries and the same level of economic development. At least in his early work, this seemed to be the case. I think that in more recent years, the data are more mixed, but at the time it was pretty clear in that direction.

He also has a very provocative paper that when a government issues debt, in fact it issues a promise to tax you in the future. And so, individuals, rationally, then understand their tax rate will go up in the future. And so, they don’t see that as net wealth but simply as a promise of future taxation. This idea is probably too extreme but was very influential for a long period of time and quite important.

And also, he had a major role in the literature on macroeconomics and time inconsistency. Time consistency is a very simple but very important idea that if I am a government, I would like to claim that I will never tax capital so people invest. But once they have invested, I’m very tempted to tax them, because they can’t quickly undo that investment.

Kate: So as for Mike Jensen, I would say he’s definitely a financial economist. To the extent that he’s very much within one field, maybe he’s a hedgehog. But within finance I think he’s sort of a fox, because he’s known for a lot of different ideas. For example, Jensen’s alpha is now, both in industry and in academia, a very popular way of measuring whether a company is outperforming other companies or the market. And he’s also well known for his research with Meckling on the theory of the firm, which, among other things, informs us on how we should think about how executives make decisions.

Luigi: I think Mike Jensen would be a fairly controversial candidate, because he took some very strong position over the years. One of the papers of his that is highly cited is a paper about the fact that executives were not paid enough, that he wanted to see more pay-for-performance sensitivity in executive pay, which, by and large, also meant more pay. To his credit, his positions have evolved over time. His more recent work is about how the compensation might actually lead executives to lie and to bad outcomes. His most famous one is about agency costs of managers. The fact that when managers run a firm, they might appropriate some of the value of that firm, and the reason why we need to have either contracts or financial structures to undo that risk is an important driver of financial decisions. So, that paper was written back in 1976 and has been extremely influential in the financial literature for the next almost 50 years.

He also shares with Gene Fama the merit to have invented a method that is widely used that is called the event study: how to distill from the stock price the impact of particular news on the stock price and separate to the effect of noise, what happens otherwise.

He also coauthored with Gene Fama some important work on organizations and, in particular, the role that reputations play in disciplining the board of directors, the fact that they try to behave properly in anticipation of what happens in the labor market subsequently. But I think that he would be a fairly controversial figure even if he has been incredibly influential in the field of financial economics.

Kate: The last person would be David Kreps at Stanford, and he’s best known for his work in game theory, sequential games or dynamic games. This sounds sort of complicated, but I think it’s actually somewhat intuitive. You might have heard of the prisoner’s dilemma, where if you separate two prisoners who, let’s say, have done something wrong. In theory it might be best if they both said that they didn’t do anything, because then there would be no evidence that they did any wrong, and they wouldn’t be able to extract a confession, so they would both be best off if they cooperated somehow and lied and said they didn’t do anything. But the police are pressuring each prisoner separately to confess or give a confession that the other person did it, and if each one of those prisoners then rats out the other person, they might both be in for a long sentence.

This is what’s known as a one-shot game by economists, but there are a lot of situations in real life that are actually repeated games, where you have situations in which there are multiple players that have to come to a decision, and they have to make that same sort of decision over and over again, in the course of, let’s say, managing a company or making some sort of corporate decision. So, the prisoner’s dilemma might change if the dilemma happens over and over again, because you know that it’s going to happen again. And so, in these cases, something like reputation might really matter. Do you have the reputation of being a liar? Do you have the reputation for cooperating? This is the kind of work that David Kreps has done, along with Paul Milgrom and Robert Wilson, also from Stanford. And they are very well cited for this work, and they’re probably in the running for a Nobel Prize, if not this year, then sometime soon.

Luigi: His work can be used to rationalize Donald Trump because reputation matters. If you have a reputation of being a little bit crazy, people might be scared by you, because in many repeated games situations, one of the problems is that you’re not sure that the other person will carry through with a threat because it’s not in his or her incentive. But if you are crazy, if you do not always behave rationally, that threat all of a sudden becomes credible and you can actually scare your competitors more, or the people playing with you more, by showing some signs that, at least occasionally, you are crazy. So, it’s a very good description of the meta-rationality of Trump’s behavior.

Kate: Yeah, I mean, I think part of the reason this work is so influential is because it can be applied from everything to how our political leaders act, to how business executives make decisions, to how children decide whether or not to lie to their parents. By the way, did I tell you that I was in the prisoner’s dilemma a few days ago?

Luigi: You got arrested?

Kate: No, so I wasn’t arrested, but I was trying to travel to a different country with my fiancé, and we had different reasons for traveling, and for whatever reason, the security on the US side … So, we’re going abroad, but they had security here in the US, so they detained us and they separated us, and they questioned us in different rooms. So, they were looking for us to give different answers to something, and I was terrified the whole time, because I knew what they were doing. Part of what’s difficult in our relationship is that I go back and forth between Washington and New York a lot, and so for questions like, “Do you live together?” I don’t really have a straight answer, and so it seems like we’re very suspicious. And so, we barely made the flight, because they were worried that we were spies or something.

Luigi: I think you definitely look like one.

Kate: Thanks, Luigi. I’ll take that as a compliment.

Luigi: Absolutely, Mata Hari.

Kate: OK, so, if not one of these three people, then who else might be up for a Nobel Prize, and what other criteria might the committee consider?

Luigi: The thing that the Nobel Prize committee cares about the most, I’m sorry to say, is their own reputation. So, they don’t want somebody that in some sense is tainted or will by association taint the Nobel Prize. And actually, the most interesting case is John Nash.

Audio clip: John Nash was one of the most brilliant minds of his generation. Welcome to Princeton. Who among you will be the next Einstein? Find a truly original idea. And it’s the only way I will have distinguished myself. It is the only way I’ll ever matter.

Luigi: And he is the protagonist of the movie A Beautiful Mind. One of the greatest minds in economics that invented some of the most important equilibria concepts we all use. He basically lost his mind, for many years he was not considered in the running because he was not completely well from a mental point of view.

Speaker 5: The awards are substantial. They require private funding as such. The image of the Nobel is...

Speaker 6: Oh, I see. So, you came here to find out if I was crazy, find out if I could screw everything up if I actually won it?

Luigi: But eventually he got the Nobel Prize before he passed away and I think deservedly so. So, I think that, even in that case, they overcame the potential risk involved and they gave it to the person who deserved it.

Speaker 7: Dr. John Nash, your analysis of equilibria and noncooperative games and all your other contributions to game theory have had a profound effect on the way economic theory has developed in the last two decades.

Luigi: It is very expensive for Sweden to damage the image of the Nobel Prize. It is actually a very big national institution. The ceremony is on the day of, I think, the birth of Alfred Nobel, which happens to be at the beginning of December. So, first of all, it’s a fantastic tourist ploy because nobody wants to visit Stockholm at the beginning of December, and the place is full and all the major hotels are full because of the Nobel Prize. But the other thing, which is quite amazing, is that the night of the Nobel Prize, the entire conference is video-transmitted to the country. It’d be like the Oscar ceremony. It is something that a lot of people watch.

Kate: Oh, wow.

Luigi: It is in the same way in which you might watch the Emmy awards or the Oscar awards, people watch the Nobel Prize awards. And I have to say, it’s pretty cool that a country has this level of sophistication to appreciate that.

Kate: That’s kind of cool.

Luigi: It seems to me, also from a purely descriptive point of view, the Nobel committee likes to turn over areas. So, last year they gave a Nobel Prize in macro/growth. It is unlikely that are going to give another prize to the same area this year. And then there is a little secret that I’m going to reveal. The Nobel committee does run periodic conferences, and these conferences are actually very important, because they tend to collect researchers in a certain area so that they can assess who is the leader in that area. If you know which conferences the Nobel committee has run recently, you have a pretty good predictor of who can win in the next few years. This is not a one-to-one relationship, it’s not necessarily that year or the year after, but the very fact that the Nobel committee is investigating the area suggests that they are interested in finding out who is the king of that area and potentially giving a prize in that area.

Kate: Do you have any inside information on which conferences have been run recently?

Luigi: I do know that last year they ran a conference on banking, and so I do think that banking is a big topic. No one has received a Nobel Prize in banking yet. I think one is probably due.

Kate: Let’s assume that it is someone in banking this year who’s going to win. Who do you think would be one of the top contenders for the Nobel Prize?

Luigi: I’m biased, but one of the top contenders is my colleague, Douglas Diamond. He is probably the most important theorist in banking. He has two key papers in the early ’80s trying to explain why banks are structured the way they are. They are super highly cited and very influential.

Kate: I think probably his most well-known paper, at least it’s often taught to early-stage economists, is a paper on bank runs that was coauthored with Philip Dybvig, and the idea behind that is kind of like your favorite movie, Luigi, the one—

Luigi: It’s a Wonderful Life.

Kate: It’s a Wonderful Life. Exactly.

Speaker 8: Oh, just remember that this thing isn’t as black as it appears.

Kate: Where, if you have your deposits in a bank and you suspect that that bank isn’t doing very well, then you want to go to the bank and withdraw your deposits right away, assuming that you don’t have deposit insurance.

Speaker 8: I have some news for you, folks. I was just talking to old man Potter and he’s guaranteed cash payments to the bank. The bank’s going to reopen next week.

Speaker 9: But George, I’ve got my money here. Can he guarantee this place?

Speaker 8: Well, no, Charlie, I didn’t even ask him. We don’t need Potter over here.

Speaker 9: Then I’ll take mine now.

Kate: And so that sort of run risk leads to a self-fulfilling prophecy that can lead banks to fail, and so that’s an important reason why we have the Federal Deposit Insurance Corporation check.

Douglas Diamond: It’s interesting. The view of runs in this paper, we’ll come back to this, is very much about panics. An extension of, “Oh my God, somebody’s failing, I better take my money out.” So, that’s sort of what people like to call the sunspot thing, although, even though it is a quote from my paper with Phil Dybvig, the point of that paper was not to say that they’re caused by sunspots, but that anything that makes you fear a run increases the incentive to run. Although there actually is experimental evidence that things like sunspots can do this, so I’m not going to go that far, but I don’t think there has been outside the laboratory.

Luigi: I think that the unique aspect of that contribution is that he explains why banks might optimally set up in a way that leads to this fragility. It is the fact that they provide a form of insurance to depositors that would not be available in the marketplace. And this insurance requires that they issue, as a liability, some demand deposits, and these demand deposits have these unfortunate consequences that may lead to inefficient bank runs. So, he really provides a new way of thinking about the problem of bank runs.

Kate: OK. So, aside from the people we’ve mentioned so far, do you have any personal thoughts or convictions on who might win the Nobel Prize this year?

Luigi: Certainly. A likely candidate in the near future is Ernst Fehr. He is a behavioral economist out of Switzerland. He has written a lot on prosocial preferences and how this impacts decisions, and in particular the idea of fairness and how this impacts economic choices. I don’t expect it to be this year because, as I said, there is some turnover across fields, and Richard Thaler won a couple of years ago, and he was also a behavioral economist. I think it’s a bit too close for that. And there is a disproportionate amount of Nobel Prizes in the United States, so occasionally having a Nobel Prize in Europe is something that certainly Swedish people like. So, I think that for all these reasons, I think he’s an obvious choice, but probably not for this year.

Kate, what are your predictions?

Kate: I think if we’re trying to consider the idea of category turnover, it might be time for a labor economist or a group of labor economists to win the Nobel Prize, as well as a group of people who do what’s called by some applied micro. But really, it’s just empirical work, right? Work using data. And if we were to think about this field, I think three names would come to mind. Those would be David Card, Josh Angrist and Janet Currie.

So, David Card has done interesting research on things like the relationship between the minimum wage and employment.

David Card: For example, the minimum wage would have increased in one state. For example, the study I did with my colleague Alan Krueger years ago was in New Jersey and in another nearby state, the minimum wage was held constant. And so, we compared what happened to the fast-food restaurants in those two states. Historically, critics of the minimum wage thought that higher minimum wage had significant costs in terms of lost jobs. And my research suggested that those costs might be smaller in many cases.

Kate: By the way, with Alan Krueger, who unfortunately passed away this year, which was a pretty big blow to all of the economics profession. But in addition to his work on the minimum wage, he’s done a lot of interesting work on education and later earnings, and I think that that’s where there’s sort of a tie-in to work that Josh Angrist has done. He’s also done work on education, he’s done some interesting stuff on draft lotteries. And Janet Currie, even though now she’s specializing more in health and economics, she has done work on early-stage education and things like maternal health and later adults’ outcomes.

Janet Currie: My contribution has been to look at the whole life cycle and show that, actually, even though we have increases in economic inequality for children, we see decreases in inequality in mortality. In other words, poor children are becoming less likely to die relative to rich children than they were 20 years ago.

Kate: And so, I think that all of these economists are united in a somewhat similar research agenda. I think it’s an agenda that could be popular now. It’s sort of a woke agenda, and so it feeds into the current political climate. And I think that they’ve all made important methodological contributions, as well, by contributing to how we think about causality.

Luigi: Yeah, I think it would be a very appropriate Nobel Prize, but it’s too bad that Alan Krueger is not around us to receive it, because I think that among those people, he was probably the one who deserved it the most. He was one of the first, no, the first to introduce the idea of these so-called natural experiments. I think he was one of the pioneers in this methodology, and it’s too bad that he is not among us to receive the honor that he deserves.

Kate: Agreed.

So, Luigi, we’ve discussed a lot of people. Who would your final prediction be?

Luigi: I think I’ll go for Doug Diamond. I might be biased, but I’ll go for Doug Diamond.

Kate: Well, we’ll see.

Luigi: One thing that we have not discussed, which will be interesting to discuss, is how important this prize is for people and how it shapes the activity of so many researchers around the world. It was a brilliant initiative by Nobel and by the central bank of Sweden afterward, because they were the first ones to create this general prize, and now they have the status and the prestige. And so, a lot of people pay attention in a disproportionate way. Because now I think the win is a million, a million and a half, so it’s a significant amount of money, but it’s not a life-changing amount of money for many of the people who receive the prize. And if you think about how much effort is put in trying to obtain it and how important this ranking and this award are all over the world, I think that Sweden has done incredibly well for itself.

If you are consistent about a topic, you’re much more likely to get the Nobel Prize than if you are scattered all over the place. You want to associate your name to a new idea that has no more than two other names on it, because if you are the fourth in the field, chances are that you’re not going to get the Nobel Prize in that field, so you’re better off trying in a different field. And I think that when you see all the faculty so still dedicated to their work, I think in part it is because they are still in the running. Whether they are or they perceive they are, it doesn’t make a difference; it still works wonders.

I’m reminded of the work of Sherwin Rosen, who unfortunately passed away, he would have won the Nobel Prize. But he has some work on tournaments, and he claims that tournaments are very good in motivating effort with a relatively small prize, because everybody tends to think they’re going to be the one winning, and so they accept more effort.

Kate: I agree with you, to an extent. I think that when you’re younger it doesn’t matter. I mean, it’s way too far off. And also, the econ Nobel has a reputation for being awarded to older people, as we’ve mentioned. But in the beginning of your career, when you’re a PhD student, you’re only concerned with getting a job. And so, there’s this job-market process where you have to come up with a packet of work and then present it around to schools. That’s the only real thing that’s on your mind. And then, until you have tenure, it’s just a matter of building a portfolio that will look good for tenure, which is getting a certain number of publications in a small number of top journals that matters. And the Nobel Prize is not present on anyone’s mind, at least not anyone that I know. But then I think you’re right, and once you have tenure, what are the incentives to keep working harder if you can’t get fired? Or, you’re given absolute academic freedom, what sort of discipline is there to force you to keep churning out those papers? And I agree with you that at that point, the Nobel Prize is probably a pretty strong motivator.

Luigi: But actually, Kate, I think that you are not ambitious enough.

Kate: I should be going for the Nobel Prize?

Luigi: Yeah. A lot of young faculty, when they start, they already have their eyes on the Clark Medal, which is the prize that you receive as the best economist below 40. And then the Nobel Prize. I don’t want to name names, but I do know of people that keep very close count of, or used to keep, a very close count of their citations, because they were in the running for the Clark Medal. So, I think they do have an impact on the more ambitious people.

Kate: Well, I’m not going to argue with that. So, what do we think? Like, 400 people are directly motivated by the Nobel Prize?

Luigi: Yeah. Let’s say that. That’s not a minor thing: for $1 million a year you motivate 400 people working super hard. I think that’s a pretty good deal.

Kate: Yeah. It’s nothing to sneeze at.

Luigi: OK. So, Kate, do you think that the Nobel Prize is a capital-is or capitalisn’t?

Kate: I think it’s a little bit of a silly question because is a prize—

Luigi: Thank you.

Kate: —that recognizes commitment to pushing the boundaries of thought and economics a capitalisn’t? I mean, no, of course not. It’s a good thing and it motivates some people to work hard, so I’m a fan of it, as long as it’s not distributed in some sort of biased way or in a way that discourages people, and I don’t think that it is. So, I’m a fan. What do you think, Luigi?

Luigi: I think it’s actually capitalism at its best. It’s rewarding people with a combination of money and prestige to produce research, which, by the way, is a public good. Now, let’s put economics aside for a second, but think about physical science, think about medicine, think about chemistry and think about the impact on the world economy of those discoveries. We all benefit tremendously from those discoveries, and those discoveries are, in part, motivated by such a relatively small prize. So, I think it is a very efficient way to get a lot of smart people to work very hard, by and large for the benefit of society.