Month: October 2010

This is a prize for the importance of economic heterogeneity and the importance of second-order effects.  The cited labor market imperfections cannot be cured by reflating nominal demand, although that policy may be desirable for other reasons.  Mortensen and Pissarides have an explicitly Schumpeterian approach and their work represents one version of a "recalculation" argument.  (Peter Diamond in contrast does not draw out that aspect of the problem and I think of the three as each a quite different kind of economist.)  You can think of Mortensen and Pissarides as providing one reason why private recalculation takes longer than is socially optimal and how this might be fixed.  Their work shows how cyclical and structural phenomena operate together and must be analyzed together.  In the last twenty years their work on labor markets has been much more influential, and rightly so, than traditional Keynesian approaches.  Furthermore their work has dissolved the entire characterization of "Keynes vs. whomever" as out of date.  Their work has much influenced my blogging on the recent employment crisis.

See my Mortensen post for his work with Mortensen, which encompasses some of his most important contributions.  He teaches at LSE and his home page is here.  His Wikipedia page is here.  A brief bio is here.  His CV is here and he was born in Cyprus as a Greek Cypriot.  Here are some working papers.  

Here is Pissarides on Google Scholar.  Here is his book on equilibrium unemployment theory.  He has a very good paper on hysteresis and how originally short-term unemployment can worsen and persist.  He emphasized that point in today's phone interview.

Here is his 2003 paper praising British labor market policy:

Unemployment in Britain has fallen from high European-style levels to US levels. I argue that the key reasons are first the reform of monetary policy, in 1993 with the adoption of inflation targeting and in 1997 with the establishment of the independent Monetary Policy Committee, and second the decline of trade union power. I interpret the reform of monetary policy as an institutional change that reduced inflationary expectations in the face of falling unemployment. The decline of trade union power contributed to the control of wage inflation. The major continental economies failed to match UK performance because of institutional rigidities, despite low inflation expectations.

For the contrast with the Continent, see here and here.

Of the three winners, I think of Pissarides as the least Keynesian of the trio. This is a big victory for "not just Keynesian" visions of the labor market and macroeconomics more generally. Garett Jones called this a prize for "relationship macro" and it also can be said that sophisticated versions of real business cycle theory are alive and well.

Here is his very good 2009 Econometrica piece on wage stickiness, abstract:

I study the cyclical behavior of an equilibrium search model with endogenous job creation and destruction, with focus the model’s failure to match the observed cyclical volatility of unemployment. Job creation in the model is influenced by wages in new matches. I summarize microeconometric evidence on wages in new matches and show that the key model elasticities are consistent with the evidence. Therefore explanations of the unemployment volatility puzzle have to preserve the cyclical volatility of wages. I discuss some extensions of the model that can increase cyclical unemployment volatility through mechanisms other than wage stickiness.

He has been on the Northwestern faculty since 1965 and he is a Carnegie-Mellon Ph.D. (I am surprised to read how old he is).  His Wikipedia page is here and his home page is here.  Here is a short bio.  Here is Mortensen on Google Scholar.

His seminal paper is: D. Mortensen and C. Pissarides (1994), 'Job creation and job destruction in the theory of unemployment.' Review of Economic Studies 61, pp. 397–415.

This is one of the best and most important papers in the last twenty years of economics (note that it builds upon the analysis of Diamond).  Here is the abstract:

In this paper we model a job-specific shock process in the matching model of unemployment with non-cooperative wage behaviour. We obtain endogenous job creation and job destruction processes and study their properties. We show that an aggregate shock induces negative correlation between job creation and job destruction whereas a dispersion shock induces positive correlation. The job destruction process is shown to have more volatile dynamics than the job creation process. In simulations we show that an aggregate shock process proxies reasonably well the cyclical behaviour of job creation and job destruction in the United States.

The key point in this paper is to show how unexploited gains from trade can persist in labor markets.  It seems odd that desperate workers would simply turn down jobs, even for lower wages, so why doesn't an economy move back rapidly to full employment?  One way of putting the point is that negative shocks alter search behavior by both workers and employers and so fewer favorable matches come about.  In particular, the rate of job destruction is extremely high.  There is also an asymmetry between job creation and job destruction, due to option value, and thus discrete cut-offs for job creation and job destruction, and that leads to a central result of the paper:

The dynamics of job destruction, however, are different, because the rise in the reservation productivity…leads to an immediate destruction of all jobs with idiosyncratic components between the two reservation productivities. Job destruction also rises for reasons similar to the ones that led to its decrease when price increased, since with higher reservation productivity firms are more likely to destroy jobs as they are hit by job-specific shocks. But the increase in job destruction immediately after the cyclical downturn has no counterpart in the behaviour of the job destruction rate when price increases, or in the behaviour of the job creation rate. This imparts a cyclical asymmetry in the job destruction rate and in the dynamic behaviour of unemployment. The short-run cyclicality of the job destruction rate increases, the job destruction rate leads the job creation rate as a cause of the rise in unemployment and the speed of change of unemployment at the start of recession is faster than its speed of change at the start of the boom…

That's explaining a lot of the observed time series behavior of unemployment, and in a strict rational model with no arbitrary assumptions about market imperfections.  (And the simulation supports the analysis and its relevance.)  You are, as an employer, quite willing to destroy a job because you still have the option of rehiring favorably later on; keeping a job going doesn't yield the same calculus of benefits.  Here is a good summary passage from the paper:

We have shown that at higher common components of labour productivity (alternatively when the aggregate price distribution translates to the right), the probability that an unemployed worker finds a job is higher and the probability that a job is destroyed is lower within given finite lengths of time. An examination of the dynamics of job creation and job destruction when it is known that labour productivity changes randomly has revealed that the anticipation of cyclical change reduces the cyclicality of job creation, and the short-run response of job destruction to shocks increases the cyclicality of job destruction…

As I read this work, it shows that "cyclical" and "structural" causes of unemployment are not always conceptually distinct but rather they interact in harmful ways.  An implication is that looking at the Beveridge Curve (which is stocks, not flows) won't necessarily identify the nature of unemployment at any point in time.

If there was ever a Nobel Prize given for a single very important paper, it is this one.

Here is a paper extending and defending his basic unemployment model.  Here is Mortensen's lengthy 1984 survey on seach and unemployment.  Here is his later, 1999 survey with Pissarides, which also recaps their own work.

In some of the policy applications of these models there are mixed employment effects from unemployment insurance (not necessarily negative, because waiting relieves crowding in the search queue) and positive effects from a job destruction tax.  Wage subsidies don't always work out well for job creation.  A key point is to analyze not just the first-order effect of the labor market policy but also its incidence, and thus its second-order effects on search and job matching.  Mortensen, along with Pissarides, has made the analysis of labor market policy considerably more sophisticated; here is one presentation of their main policy results.  Here is another version of the same.

Here is his piece on the importance of personal contacts in labor markets.

Mortensen has a whole book on wage dispersion, reviewed here.  The key question is why workers with similar characteristics often are paid differently and the answers lie in job search frictions.

Here is a recent paper on growth through product innovation (you can google to an ungated version, though the pdf has no link).  Both in this paper and in the job market work you can see the strong influence of Schumpeter, and the idea of creative destruction, on the research of Mortensen.  It's about time people stopped laughing at "recalculation" models of our downturn because one version of them just won a Nobel Prize.

In sum, picking Mortensen (and his co-author Pissarides) shows that the committee sees unemployment as a central issue of the day.  At the same time, there aren't always easy answers to this problem.

Here is Diamond's home page, here is Diamond on Wikipedia.  Diamond has been at MIT since 1970 and he is considered one of the bulwarks there, having produced many excellent students, including Bernanke and Andrei Shleifer.  Here is the bit of most current interest:

On April 29, 2010, Diamond was announced by Barack Obama as one of three nominees to fill the three vacancies then present on the Federal Reserve Board, along with Janet Yellen and Sarah Bloom Raskin.^[5] On August 5 the Senate returned Diamond's nomination to the White House, effectively rejecting his nomination. Ben Bernanke, the current Chairman of the Fed, was once a student of Diamond.

Some of Diamond's early work was in capital theory, as he outlined the conditions under which, in dynamic growth models, the level of capital could be inefficient.  Read this paper, from 1965, which is still his most frequently cited work.  It helped produce a standard framework for thinking about national debt and economic growth.

Diamond has contributed plenty to the theory of optimal taxation, in particular when linear commodity taxes are optimal and how to use the tax system for redistribution.  See this paper with James Mirrlees (also a Nobel Laureate) and also this one.  One implication is that taxing inputs often leads to more distortion than taxing outputs and you can think of this as one possible motivation for a consumption tax.

Here is Diamond's 1982 paper on macro and search theory, which I think of as his most influential.  The abstract is classic Diamond:

Equilibrium is analyzed by a simple barter model with identical risk-neutral agents where trade is coordinated by a stochastic matching process.  It is shown that there are multiple rational expectations equilibria, with all non-corner solution equilibria inefficient.  This implies that an economy with this type of trade friction does not have a unique rate of natural unemployment.

The relationship to the current day U.S. is striking.  One point he stresses is that subsidization of production can make sense and also that there can be real costs of converging to the lowest possible rate of unemployment too quickly.  This remains an important "framework" paper for analyzing the interaction of search and aggregate demand.  His other 1982 search paper implies that labor mobility will be less than is socially optimal.  This paper on search theory shows that unemployment compensation can lead to better job matches, by limiting crowding externalities in the job market.

He and Olivier Blanchard wrote a classic piece on the Beveridge Curve, which is about the relationship between job vacacies and the unemployment rate.  Some commentators cite the Beveridge Curve as evidence for structural unemployment, although this is controversial.

Diamond has written a great deal on social security, often at the applied level.  Here is his paper criticizing social security privatization in Chile for its high costs.  Here is his survey on social security reform proposals.  Here is his paper on macro and social security reform.  Here is a very good European talk he gave on pension issues.  Diamond wrote a book with Peter Orszag on social security and he has been a major influence on Democratic Party thinking on this issue; the book looks closely at progressive price indexing rather than wage indexing of benefits.  Here is a CBO summary and analysis of the plan.  Much of Diamond's more formal social security analysis stresses risk-sharing issues and in general he often points out that social security proposals, including Bush's privatization idea, are not well-grounded in rigorous analysis.

Here Diamond tells us not to expect 7 percent stock returns for the ongoing future.

Diamond has many interests, here is his survey on contingent valuation and whether some number is better to use than no number at all.  He and Stiglitz wrote a famous paper on risk and risk aversion.

Personally, my favorite Diamond paper is this short gem on the evaluation of infiinite utlity streams; it will make your head spin, as it asks whether we have coherent means of thinking about prospects with infinite utility and in general how intertemporal utility streams should be ordered.  See also his related paper on stationary utility, co-authored with T.J. Koopmans.

Here is his short introduction on behavioral economics.

I think of Diamond as the classic MIT economist, especially of the earlier, pre-Acemoglu generation.  Lots of theoretical rigor, though sometimes his theory pieces don't have a simple or simply analytic punchline.  There is greater concern with risk, and stability conditions, and dynamic and border conditions, than you would see in a Chicago theory paper.  There is a strong emphasis on the ability of government to implement welfare-improving schemes of the sort found in social democracies.  The approach is quite technocratic — solve and advise.  Public choice and political economy considerations take a back seat.  High IQ.  Of the MIT economists, he has done the most to pursue the Samuelson tradition of having a universal method and very broad interests.  His papers remain central to public finance, welfare economic, intertemporal choice, search theory, macroeconomics, and other areas.  His policy impact on social security has been significant.

Addendum: Levitt comments on Diamond.

Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working.

The full column is here.  Perhaps Greg could do more to (legally) evade the estate tax, but that's hardly an argument for raising such a tax.

Alternatively, Dan Ariely asks:

Let’s say that your 1040 came with a little extra stuff: maybe a container with an alcohol content, or perchance something of the chocolate persuasion. What if your tax forms arrived in a gift box with some financial documents on the side? What if the instructions for filling out the form told you to type in your personal information and take a bite of chocolate, type in your W-2 information and drink some of the alcohol, add your deductions and try some of the nuts etc? What if we could live in a world where you actually looked forward filling out these forms?