In 1997, Robert Merton and Myron Scholes at MIT were awarded the Nobel “for a new method to determine the value of derivatives”.
The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was instituted in 1968 by the Swedish central bank, and laureates are selected by the Royal Swedish Academy of Sciences. It is commonly called the Nobel Prize in Economics, though the Nobel Endowment has nothing to do with it. It has mostly tended to go to scholars doing esoteric research in economics. Much of economic research has tended to be quite remote from influencing public policy. My professor at the Kennedy School of Government at Harvard University, Prof. Thomas Schelling, who taught me the “game theory” that is used in nuclear strategy, and only sometimes in economics, got an Economics Nobel for just that in 2005.
In 1997, Robert Merton and Myron Scholes at MIT were awarded the Nobel “for a new method to determine the value of derivatives”. They fathered the Black–Scholes–Merton mathematical model to “understand the dynamics of financial markets”. Their theories were put to work at the Long-Term Capital Management L.P. (LTCM), a hedge fund that used “absolute return” trading strategies combined with high financial leverage. In 1998, LTCM spectacularly imploded in the wake of the 1997 and 1998 economic crises. The theories were just theories. It also provided us with an additional insight into the notion of “ceteris paribus”. The concept of “ceteris paribus” is important in economics because in the real world, it is usually hard to isolate all the different variables that may influence or change the outcome of what you are studying.
Now the trend from the esoteric and philosophical is moving towards the more universally applicable. The award of the Nobel to the husband and wife team of Abhijit Banerjee and Esther Duflo at MIT and Michael Kremer at Harvard was for “their experimental approach to alleviating global poverty”. The Swedish Academy of Sciences noted: “The laureates’ research findings – and those of the researchers following in their footsteps – have dramatically improved our ability to fight poverty in practice. As a direct result of one of their studies, more than five million Indian children have benefitted from effective programmes of remedial tutoring in schools. Another example is the heavy subsidies for preventive healthcare that have been introduced in many countries.” The research led to the raising of vaccination rates and educational standards in schools, touching hundreds of millions of people across the globe.
Last year two American economists, William Nordhaus and Paul Romer, were awarded the Nobel Prize in Economics for their work in two diverse areas, but current concerns. Nordhaus won it for his warning policymakers during the first stirrings of concern about climate change in the 1970s that their economic models were not properly taking account of the impact of global warming, and he is seen as one of the pioneers of environmental economics.
The co-winner – Romer – is seen as the prime mover behind the endogenous growth theory, “the notion that countries can improve their underlying performance if they concentrate on supply-side measures such as research and development, innovation and skills”. This simply means developing nations that want to get out of their rut, like India, must invest in quality education and R&D. Instead, our bureaucratic centralism has created a huge system whose outcomes are so low-grade, that mediocrity passes off as brilliance. The fact that Indian students and scholars have to go abroad to fully harness their brilliance and gain recognition tells us what has gone wrong with our system.
Paul Romer has argued: “Technological change can be accelerated by the targeted use of state interventions in areas such as R&D tax credits and patent regulation”. He called it “post-colonial endogenous growth theory”. This famously inspired an Oxford don, the economist Derek Morris, to write an ode to it. It’s the history of economic theory in verse and is very witty and clever. The relevant verse for us is:
“Only inventions seemed to have any effect/ And from where these arose everyone was quite bereft/ So people then began to get rather weary/ Of the once almighty neoclassical growth theory/ A new explanation arrived,/ over which there was quite a fuss/
Technical progress — innovation, ideas — were ‘endogenous’/ Invention was crucial but needed embodiment/ In people – in skills – and in capital investment/ So these were important to make growth shine/ Although others had known this for a very long time.”
But how does one nurture invention without a national mood? For it is now well understood that how we do as a nation depends a great deal on how we perceive ourselves? This psychological factor is now understood to be critical to sustained economic growth.
Classical economics was linked closely with psychology. Adam Smith’s other great work was The Theory of Moral Sentiments, and dealt with the psychological principles of individual behaviour. Smith emphasised the concept of empathy, the capacity to recognise feelings that are being experienced by another being. Jeremy Bentham described “utilitarianism as the greatest happiness of the greatest number that is the measure of right and wrong” and is considered by many as the father of the welfare state. Classical economic theory, also known as laissez faire, claims that leaving individuals to make free choices in a free market results in the best allocation of resources. Since individuals made choices the emphasis was on understanding human beings and their behaviour as individual and as groups.
Neo-classical economists based their thinking on the assumptions that people have rational preferences; individuals maximise utility and firm’s profits; and people act independently.
Consequently, neo-classical economists distanced themselves from psychology and sought explanations for economic analysis heavily based on the concept of rational expectations. For most of the last century, economics became increasingly mathematical. Much of economic theory came to be presented as mathematical models, mostly calculus, to clarify assumptions and implications.
In more recent times the traditional school of economics has been given greater importance and is reflected in the award of Nobel Prizes to behavioral economists like Daniel Kahneman of Princeton University and last year to Richard Thaler. Making the announcement, the Nobel Committee said: “His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioural economics, which has had a profound impact on many areas of economic research and policy.”
There is a delicious irony in the award of the Nobel to Richard H. Thaler. He works in the University of Chicago, the nursery of neo-classical economics, where he is the Ralph and Dorothy Keller Distinguished Service Professor of Behavioural Science and Economics at the Booth School of Business. Incidentally Raghuram Rajan, who is also an economics professor, is a colleague, was at one time reported as being considered for the Nobel for his “contributions illuminating the dimensions of decisions in corporate finance”.
The dominance of the neo-classical school on the world of economics can be gauged by the fact that since the relatively recent inception of the Nobel Prize in Economics in 1968, the Chicago economics department faculty have won the Nobel as many as 12 times, twice as many as MIT, which has six Nobel laureates. Seen from Harvard University’s ivory tower, even MIT is considered as leaning more towards classical economic theory. Recent Harvard winners for economics such as Oliver Hart (2016), Alvin Roth (2012) and Eric Maskin (2007) were rewarded for their work based on mathematical empiricism than behavioural speculation. Amartya Sen (1998) was one of the few who broke this mould and won it in recognition of his work and abiding interest in welfare economics.
Every politician worth his salt knows that the national mood and perceptions are decisive in determining national outcomes. And often people do not always make rational choices, something that marketers of diverse products such as automobiles and soap, and political dreams know. Abhijit Banerjee has been a trenchant critic of Narendra Modi’s demonetisation, that he holds primarily responsible for the present economic crisis in India. This will not endear him to the powers that be. Already, the RSS batteries are firing away at his being unfamiliar with Indian conditions and even of being a foreign national. Yet the same lot had revelled in the adulation of the “Howdy, Modi” crowd of NRIs in Houston.