Nobel-Prize Winner Lars Peter Hansen on How Economics Has Helped You

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University of Chicago professor Lars Peter Hansen speaks to colleagues, student and reporters after learning he had won the Nobel Prize in Economic Sciences on October 14, 2013 in Chicago, Illinois.

The media coverage of this year’s Nobel Prize in economics was dominated by the concept of the “efficient market hypothesis,” which is narrowly defined as the idea that markets will quickly assimilate all public information about a stock. One of this year’s Nobelists, Eugene Fama, won his award for providing the empirical basis to support this view, while another Robert Shiller, was recognized for poking holes in the theory and providing evidence that markets reflect more than just the available information about a security, but the irrational emotions of human beings as well.

Reaction to the award was predictable, with liberal commentators lauding Shillers work, which supports the idea that government regulation can improve the functioning of financial markets, and conservatives praising Fama, whose work shows the power and intelligence of markets, and questions the ability of any one person or government to exceed their wisdom.

But a third economist — Lars Peter Hansen — was also recognized this year, though his work received less attention because it could not be distilled to support one political ideology or another. TIME spoke with Hansen to get his opinion on the state of economics and how this social science has affected public policy and vise-versa. The conversation has been edited for length and clarity.

TIMEHow do you explain to the lay person your contributions to economics?

Hansen:  I work on the boundary between economics and statistics in this field called econometrics. Part of my interest is understanding how you use statistics in productive ways to analyze dynamic economic models.

Part of what I was recognized for was for this notion that you can do something without doing everything. Suppose you’re interested in the connections between financial markets and the macro economy. In order to do that using statistical methods, you have to have a formal model of the macro economy and financial markets, and to do that requires a whole lot of inputs and it’s hard to produce all of those credible inputs. So the question is how do you do that without having a full-blown model of everything? My work helped to create methods to be able to study these complicated systems with limited information.

TIME: Frederick Hayek argued that there should be no Nobel Prize in economics because “the Nobel Prize confers on an individual an authority which in economics no man ought to possess.” Do you agree?

Hansen: I would prefer myself the first couple paragraphs in [Milton] Friedman’s address which makes a strong case for economics as a science, and how the scientific underpinnings are critical to any discussions of what are prudent policies going forward.

The way that I look at it is, that if you look at subjects where there are the biggest discrepancies between what policy actions should be taken, those are often places where the empirical evidence we have is weakest. The more that we can learn, the more that we can improve our understanding of the economics, the more it will narrow these policy discussions.

There is a big divergence between views on a variety of policy issues from fiscal stimulus to financial regulation. It’s my hope and my ambition for the economics profession that as we advance our knowledge, that those discussions will narrow in their focus, and that it will help to have more prudent policy making down the road.

TIME: What’s an example of a public policy debate that has been solved by economics in the past fifty years?

Hansen: Solved is a little bit extreme here, but I think we understand much more about how education and skill formation affects labor markets. We better understand how education effects compensation and income inequality and the like. I don’t think we have everything settled, but we’ve made some advances.

I think pre-crisis at least, we’ve understood a lot better the role of monetary policy in the economy. The financial crisis has opened up some new knowledge gaps, and it’s giving us some modeling challenges going forward as new evidence often does. But as far as how monetary policy operates in less turbulent times, we have a good understanding of the implications of different policies.

An important question going forward is on the fiscal side and the consequences of long-term fiscal uncertainty for instance. That’s an issue we’re facing now, and our knowledge is a lot weaker on that front.

TIME: How has economics helped the average person?

Hansen: I think the understanding of the role of markets has really helped advance the values of  entrepreneurship. It’s helped shape public policy discussions in a whole variety of ways. Now there’s a lot more discussion when designing public policy on the effects of those policies on markets. Are they going to work against markets or are they going to be complimentary? Those sorts of discussions have been hugely important for average people.

It’s a science that’s a lot more limited than other sciences in our ability to experiment. It’s difficult to experiment on an entire macroeconomic system in some designed and ordered way, you kind of have to stumble upon these experiments accidentally. So there are limits to the advance of knowledge in that respect, but in my view we remain a challenging but important scientific discipline.

TIME: Has politics perverted the science of economics?

Hansen: I certainly hope not. I think when people see lots of op-eds written by economist, their presumption is that the science is getting diluted by politics. But those are just opinions, and that’s fine for what shows up in newspapers. But I think at the best research institutes and the best universities when we discuss economics we do it in terms of its own merits. I view it as inappropriate for people to go inside of classrooms and spout their political views. That’s not how you do good economics, and I think for the most part that’s not how it’s done.

TIME: Has economics perverted politics? You often hear politicians using specious economic reasoning that relies on the listeners’ limited understanding of the subject.

Hansen: Bad economics have been used for political purposes for a long time, and the only way I know how to guard against that is to get people better educated so they can see through those fallacious arguments.

TIME: What are the areas of research that excite you and what are the advances you see coming in the next couple of decades?

Hansen: I’m very interested in the issue of how uncertainty plays out in marketplaces and in discussions of public policy. Uncertainty is a really under-appreciated concept in a lot of circles. The truth is that as economists there’s stuff that we don’t know and acknowledging that should play a role in public policy.

Let me give you an example: The financial crisis exposed some gaps in our knowledge. There’s some basic things we don’t understand about how turbulence in financial markets spills over into the macroeconomy, and vice versa. But we do have to engage in some type of oversight of financial markets. It’s absolutely critical, especially when governments are propping up financial institutions.

One argument I’ve heard made is that since this is a complicated problem, this requires a complicated solution. But I would argue the opposite. Because it’s such a complicated problem and because there are so many things we don’t understand, the best approach is to do it with simplicity and transparency and worry about fine-tuning things once our knowledge base expands.

Another policy concern that should be almost dominated by uncertainty is climate change. The truth is our knowledge of climate change impacts remains rather sparse. That doesn’t mean we shouldn’t act. It may be prudent to act now because it’ll be more costly to act later, but it’s critical to recognize that we’re designing policies based on limited knowledge. In political debates that’s often stuck in the background.

TIME: This concept relates to long-term budget projections too, right? We’re making decisions now based on projections twenty to fifty years into the future. 

Absolutely, our long term fiscal situation is uncertain, and there’s a lot to be learned. We should always recognize what we don’t know. People are looking into these issues from a variety of perspectives. Some are taking a more data driven approach, while others are working more theoretically with what are called ‘decision trees’. In these complicated decisions with uncertainty, what are the smart ways to make decisions? I think the combination of these approaches could yield some really interesting results.