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A chat with Nobel Laureate Oliver Hart

I especially enjoyed the part about his interior decorating, this segment was fun too:

Hart’s appetite for complex contract negotiations has also served him well at home. He and his wife embarked on a major renovation of their house several years ago, adding new rooms to the ground floor and expanding the kitchen and backyard. Though he admits that his wife spearheaded the design, which included an open kitchen and new sitting room just off the main entrance, Hart says he negotiated the contract with the builders. “You learn right away that nothing will be completed when they say it will,” he adds with a wry smile. “So there are lessons that even I can learn.”

Here is the full FT story.  Here is The Economist covering Rita Goldberg’s second-generation Holocaust memoir; she is Hart’s wife.

Bob Dylan, Nobel Laureate!

I had heard the rumors for years, but I didn’t think it actually would happen.  My takes on a few Dylan albums:

FreeWheelin’ Bob Dylan: One of his most listenable and underrated albums, the same is true for Another Side of Bob Dylan.

Bringing It All Back Home: The album I fell in love with as a kid.  Some of it is overwrought but mostly still amazing, perhaps his highest peaks.

Highway 61 Revisited: Half of it is wonderful, but it contains excess and some so-so judgment.

Blonde on Blonde: Many see this as Dylan’s peak, but I don’t listen to it much.  Somehow the sound is a little harsh for my taste.

The Basement Tapes: The most overrated, too much murky slush and slosh.

Bob Dylan’s Greatest Hits, vol.II: The perfect medley.

Blood on the Tracks: Maybe the most consistent and listenable album, though it’s not pathbreaking in the way that the mid-sixties work was.

Time Out of Mind: An amazing “late career” work.

Dylan’s memoir is excellent, and his most underrated contribution outside of creating music is the CDs he edited for satellite radio, many hours of Dylan selecting and playing classics from early American musical history, blues, country, mixed styles, perhaps the single best look at the early evolution of American popular music.  Many hours of listening pleasure.  Bob Dylan Radio Hour.  And the Martin Scorsese four-hour bio-documentary on Dylan is one of the better movies ever made, No Direction Home it is called.

If I recall correctly, three of the Conversations with Tyler turned to the topic of Bob Dylan.  Camille Paglia loves the song “Desolation Row,” Cass Sunstein is a big fan, especially of some of the early period work, and Ezra Klein feels he is overrated, I guess that means especially overrated now.

Here are my earlier posts on Bob Dylan.  Complain all you want, I say Bob Dylan is a better and more important artist than say Philip Roth.  It’s not even close.

Congratulations to Bob Dylan, polymath!

The Performance Pay Nobel

The Nobel Prize in economics goes to Oliver Hart and Bengt Holmstrom for contract theory, the design of incentives. See Tyler’s posts below for overviews. In our textbook, Modern Principles, Tyler and I have a chapter called Managing Incentives which covers some of this work, especially related to Holmstrom’s work on performance pay. Let’s give a simplified precis (fyi, the textbook doesn’t have the math).

Suppose that you are a principal monitoring an agent who produces output. The output depends on the agent’s effort but also on noise. It wouldn’t be a very efficient contract to just reward the agent based on output since then you would mostly be responding to noise—punishing hard-working agents when the noise factors were bad and rewarding lazy agents when the noise factors were good. Not only is that unfair–if you setup a contract like this the agents will a) demand that you pay them a lot of money in the good state because they will be taking on a lot of risk and b) the agents won’t put in much effort anyway since their effort will tend to be overwhelmed by the noise, either good or bad. Thus, rewarding output alone gets you the worst of all worlds, you have to pay a lot and you don’t get much effort.

But perhaps in addition to output, y, you have a signal of effort, call it s. Both y and s signal effort with noise but together they provide more information. First, lesson – use s! In fact, the informativeness principle says you should use any and all information that might signal the agent’s effort in developing your contract. But how should you combine the information from y and s? Suppose you write a contract where the agent is paid a wage, w=B0+By*y+Bs*s where Bo is the base wage, By is the beta on y, how much weight to put on output and Bs is the weight on the s signal–think of By as the performance bonus and Bs as a subjective evaluation bonus. Then it turns out (under some assumptions etc. Canice Prendergast has a good review paper) you should weight By and Bs according to the following formula:

betaweights

that looks imposing but it’s really not.  σ^2s (sorry for the notation) is the variance of the s signal, σ^2y is the variance of the y signal. Now for the moment assume r is zero so the formula boils down to:

betaweights2

Ah, now that looks sensible because it’s an optimal information theorem. It says that you should put a high weight on y when the s signal is relatively noisy (notice that By goes to 1 as σ^2s increases) and a high weight on s when the y signal is relatively noisy. Notice also that the two betas sum to 1 which means that in this world you put all the risk on the agent. Ok, now let’s return to the first version and fill in the details. What’s r? r is a measure of risk aversion for the agent. If r is zero then the agent is risk neutral and we are in the second world where you put all the risk on the agent. If the agent is risk averse, however, then r>0 and so what happens? If r>0 then you don’t want to put all the risk on the agent because then the agent will demand too much so you take on some risk yourself and tamp down By and Bs (notice that the bigger is r the smaller are both By and Bs) and instead increase the base wage which acts as a kind of insurance against risk. So the first version combines an optimal information aggregation theorem with the economics of managing the risk-performance-pay tradeoff.

(c, by the way, is a measure of how costly effort is to the agent and so it also makes sense that the higher is c the less weight you put on performance incentives and the more on the base wage.)

Let’s also discuss some further work which is closely related to Holmstrom’s approach, tournament theory (Lazear and Rosen). When should you use absolute pay and when should you use relative pay? For example, sometimes we reward salespeople based on their sales and sometimes we reward based on which agent had the most sales, i.e. a tournament. Which is better? The great thing about relative pay is that it removes one type of noise. Suppose, for example, that sales depend on effort but also on the state of the economy. If you reward based on absolute sales then you are rewarding a lot of noise. Once again, that has two bad effects it means that you have to pay your agents a lot since you are imposing risk on them and it means that they won’t work that hard since they know they will be paid a lot when the economy is good and hardly at all when the economy is bad so in neither case do the agents have strong incentives to work hard. Suppose, however, that you have a relative pay scheme, a tournament. Now you have removed the noise coming from the state of the economy–since all the salespeople face the same economy and since there is always a first, second and third place the agent’s now have an incentive to work hard in good or bad times. Not only do they have an incentive to work hard you don’t have to pay them much of a risk premium since more of their pay is now based on their own effort rather than on noise.

But relative pay isn’t always better. If the sales agents come in different ability levels, for example, then relative pay means that neither the high ability nor the low ability agents will work hard. The high ability agents know that they don’t need to exert high effort to win and the low ability agents know that they won’t win even if they do exert high effort. Thus, if there is a lot of risk coming from agent ability then you don’t want to use tournaments. Or to put it differently, tournaments work best when agent ability is similar which is why in sports tournaments we often have divisions (over 50, under 30) or rounds.

FYI, in our textbook Tyler and I use this model to discuss when students should prefer an absolute grading scale and when they should prefer grading on a curve. Work it out!

Holmstrom’s work has lot of implications for structuring executive pay. In particular, executive pay often violates the informativeness principle. In rewarding the CEO of Ford for example, an obvious piece of information that should used in addition to the price of Ford stock is the price of GM, Toyota and Chrysler stock. If the stock of most of the automaker’s is up then you should reward the CEO of Ford less because most of the gain in Ford is probably due to the economy wide factor rather than to the efforts Ford’s CEO. For the same reasons, if GM, Toyota, and Chrysler are down but Ford is down less then you might give the Ford CEO a large bonus even though Ford’s stock price is down. Oddly, however, performance pay for executives rarely works like a tournament. As a result, CEOs are often paid based on noise.

The basic framework has since been applied in many different circumstances because principal-agent can be interpreted in many different ways employer-worker, teacher-student, regulator-banker and so forth. Thus the basic insights have been reflected in a wealth of applications each of which adds to the body of theory.

Bengt Holmström, Nobel Laureate

Again, I’ll be refreshing this post throughout the morning, keep on hitting refresh.  Here is Bengt Holmström’s home page, which includes a CV, short biography, and links to research papers.  Here is his Wikipedia page.  He has taught for a long time at MIT, was born in Finland, and is one of the most famous and influential economists in the field of contracts and industrial organization.  Here is the Swedish summary.  Here is a video explanation.  This is a nice short bio of how he was influenced by his private sector experience, recommended, not just the usual take on him.

One key question he has considered is when incentives should be high-powered or when they should be more blunt.  It is now well known that you get what you pay for; see Alex’s excellent summary on this and related points.

His most famous paper is his 1979 “Moral Hazard and Observability.”  What are the optimal sharing rules when the principal can observe outcomes but not efforts or inputs?  And how might those sharing rules lead to a less than optimal result?  This is probably the most elegant and most influential statement of how direct incentives and insurance value in a contract can conflict and hinder efficiency.  A simple example — what about deductibles in a health insurance contract?  Yes, they do encourage the customer to internalize the value of staying in better health.  But they also limit the insurance value of a contract.  That a first best outcome will not be created in this situation was part of what Holmstrom showed, and he showed it in a relatively tractable way.

If you are thinking about CEO compensation, you might turn to the work of Holmström,  the Swedes have a good summary of this paper and point:

…an optimal contract should link payment to all outcomes that can potentially provide information about actions that have been taken. This informativeness principle does not merely say that payments should depend on outcomes that can be affected by agents. For example, suppose the agent is a manager whose actions influence her own firm’s share price, but not share prices of other firms. Does that mean that the manager’s pay should depend only on her firm’s share price? The answer is no. Since share prices reflect other factors in the economy – outside the manager’s control – simply linking compensation to the firm’s share price will reward the manager for good luck and punish her for bad luck. It is better to link the manager’s pay to her firm’s share price relative to those of other, similar firms (such as those in the same industry).

That is again a result about how incentives and insurance interact.  When do you pay based on perceived effort, and when on the basis of observed outcomes, such as profits or share price?  Holmström has been the number one theorist in helping to address issues of this kind.

“Moral Hazard in Teams,”1982, is a very famous and influential paper, here is the working paper version.  Holmström showed that the optimal incentive scheme has to consider time consistency.  Sometimes good incentive schemes impose penalties on the workers/agents to get them to work harder.  But let’s say you had a worker-owned and worker-run firm.  If the workers fail, will the workers/owner impose punishments on themselves?  Maybe not.  Thus in a fairly general class of situations you need an outside residual claimant to impose and receive the penalty.  This is Holmström trying to justify one feature of the capitalist system against socialists and Marxists.

A Fine Theorem has an excellent post on his work.

Managerial Incentive Problems: A Dynamic Perspective” is another goodie, this one from 1999.  The key point is that repeated interactions, for instance with a manager, can make incentive problems worse rather than better.  The more the shareholders monitor a manager, for instance, and the more that is over a longer period of time, perhaps the manager has a greater incentive to manipulate signals of value.  When are career incentives beneficial or harmful?  This paper is the starting point in thinking through this problem.  Here is one of the possible traps: if a worker fully reveals his or her quality to the boss, the boss will use that information to capture more surplus from the worker.  So many workers don’t let on just how talented they are, so they can slack more, rather than being caught up in the dragnet of a ‘super-efficient” incentives scheme.  I have long found this to be a very important paper, it is probably my favorite by Holmström.

This 1994 investigation, based on personnel data from within firms, is actually way ahead of its time in terms of empirical methods.  It is certainly known but he never received full credit for it.

Holmström and Hart together have a very nice piece surveying the theory of contracts and theories of the firm.  With John Roberts, he has a very nice (and highly readable!) survey of economic work on theories of the boundary of the firm, recommended on the field more generally.  Not his most famous piece, but if you are looking in the applied direction, here is his survey piece with Steven Kaplan on mergers.

With Jean Tirole has has a 1997 paper “Financial Intermediation, Loanable Funds, and the Real Sector.”  This was an important precursor of the later point about how collateral constraints really can matter.  Firms and banks should be well-capitalized!  This piece was significantly influenced by the Nordic financial crises of the 1990s and it was prescient regarding later events in the United States and elsewhere.

His liquidity-based asset pricing model, with Jean Tirole, did not in its published form “take off” in the world of finance, but it is an excellent and important piece, worth revisiting as part of the puzzle of why the world has so many super-low interest rates today.

Holmström has since written much more about banking and agency problems.  His very latest piece is on banks as secret keepers, and it tries to model and explain the fundamental nature of banking and its fixed value liabilities.  Here is his piece on why financial panics are so likely to involve debt.  With Jean Tirole, he wrote a well-known paper on why government supply of liquidity services sometimes may be justified.

Here is his 2003 survey paper, with Steven Kaplan, on what is right and wrong in U.S. corporate governance.  It is a more applied side than what you often see from him.  The piece claims that, even in light of the scandals of that time, American corporate governance is not broken and will probably become better yet, though it could stand some improvement, including on the regulatory side.  Overall I view his co-authorships with Kaplan as suggesting that his overall stance toward corporations is more influenced by Chicago-style thinking than is oftetn the case at MIT.  Read his defense of asset securitization for instance.

Congratulations to Bengt Holmström!

Oliver Hart, Nobel Laureate

Here is Hart’s most famous piece, with Sandy Grossman, 1986, “The Costs and Benefits of Ownership.”  Think of it as an extension of Ronald Coase and Oliver Williamson, also two Nobel Laureates (hey, that’s a lot of prizes for one topic area…)

Why does one party ever purchase residual rights in the assets of another party?  Say for instance there is a factory firm and a coal mining firm.  The coal can be treated in a particular way to be more suitable for use in the factory.  If the factory firm buys out the coal mining company, the incentives for coal treatment differ, that is the key insight behind this model.  You can think of this as a very important modification of the Coase Theorem.  It does matter who owns the asset.  Why?  If the coal mining company owns the coal, it has one set of incentives to make ex ante improvements in the values of those assets; if the factory firm owns the coal mine, it has another set of incentives.  Part of the work in this paper is done by a bargaining axiom — if you own an asset outright, you keep a greater share of the proceeds from improving the value of that asset.  Ownership should thus migrate to those parties who have the greatest ability to improve value.

And that is a very fundamental improvement on the Coase theorem, which suggests ownership won’t matter when there is ex post contractibility.  This paper showed that for ownership not to matter there must also be ex ante contractibility about value-improving investments at earlier stages in the game, an unlikely assumption to hold.

This is a tricky paper to master.  It has all kinds of assumptions built in about ownership, control, and residual claimancy, which do not move together in simple ways.  Eventually Hart (working with others) cleaned up the assumptions and produced a more transparent model of this process.  This paper is a — I should say the —  starting point for thinking about mergers, vertical integration, and other questions of corporate ownership and contract and control.  Bengt Holmström of all people wrote a very nice appreciation of the paper.

What about Grossman, I hear you wondering?  I would have guessed he would have shared in the Prize, as he has other seminal papers about information and much of Hart’s key work is co-authored with him.  On the bright side for him, he has made hundreds of millions of dollars running a hedge fund.

Hart is a true gentleman and he has a very nice British accent.  He is very highly respected by his peers.  Here is his Wikipedia page.  Here is his home page, he is now at Harvard but spent part of his career at MIT.  Here is his vita.  Here is Hart on Google Scholar.  Here is the Nobel survey essay from Sweden.  Here is a video explanation.

His second best known piece is “Property Rights and the Nature of the Firm,” with John Moore, 1990.  This is again a model and series of parables about ownership and the allocation of rights, but with some twists on the earlier Grossman and Hart piece.  The key point is to not allow inessential agents to achieve blocking power of value creation.  The authors tell a story about a venture with a tycoon, a boat owner, and a chef, all of whom might organize a voyage together.  The tycoon and the boat owner are essential, so one of them should own the boat, and then they can split most of the surplus from the voyage and pay the chef his or her marginal product.  Value creation then proceeds.  Alternatively, if the chef owns the boat, he has potential blocking power and the surplus has to be split three ways.  That may result in some loss of value, due to a tougher bargaining problem, higher transactions costs, and a chance there won’t be enough surplus to cover the most significant investments.  Parties who create a lot of value should own things is the central message here, and this is another key paper for thinking about contracts, ownership, and what kind of business arrangements induce investment in idiosyncratic assets, yet another follow-up on the work of previous Laureates Coase and also Oliver Williamson.

In case you hadn’t figured it out by now, Oliver Hart is basically a theorist in his major lines of research.

Another famous paper by Grossman and Hart is “Takeover Bids, the Free Rider Problem, and the Theory of the Corporation.”  One of Alex’s most interesting papers is an extension of this work, so I suspect he’ll be covering it in detail.   In a nutshell, this model helps explain why a lot of value-maximizing takeover don’t happen, or why it is hard to buy up a whole city block and renovate it.  Let’s for instance a corporation currently is valued at $80 a share, and a raider has a good plan to make the company worth $100 a share.  The raider then  comes along and offers you, a shareholder, $90 for each of your shares.  Will you sell?  Well, it depends what you think the other shareholders will do.  But you might not sell, instead seeking to hold on for the ride.  If others sell, you can get $100 in value instead of $90.  But if everyone feels this way, then no one sells and the bid fails.  Then you might sell at $90 after all, but then no one will sell after all…and so on.  A tough problem, but this is a very important piece in understanding the limitations of various kinds of takeovers.  Right now my security device won’t let me link to the paper but try googling the title.

Hart’s 1983 paper with Sandy Grossman was at the time a breakthrough and highly rigorous means of modeling the principal-agent problem.  It is in Econometrica and quite hard for many people to read.  Economists had been modeling principal-agent problems through the notion of a participation constraint.  Have the contract give incentives, subject to the proviso that it is still worthwhile for the agents to be involved in the trades.  But Mirrlees had pointed out this can give misleading results when there is not automatically a unique solution to the problem at hand.  Grossman and Hart reconceptualized the math into a convex programming problem.  Theorists love the paper, and it was highly influential when it came out.

Here is Hart and Moore on incomplete contracts and renegotiation.  This paper is connected to the Nobel Prize for Jean Tirole two years ago.  How can you write a contract so a) parties will make the appropriate relationship-specific investments, and b) it doesn’t have to be renegotiated all of the time?  Again, Hart’s work is obsessed with this idea of value maximization within corporate endeavors and possible obstacles to such value maximization.

By the way, here is Hart, with Shleifer and Vishny, on why the private sector probably should not be allowed to own and run prisons.  The incentive to cut costs is too strong!  Government ownership will instead, in their view, create more value maximization because the government won’t have the same profit incentive to skimp on quality along various margins.  This paper has been highly influential in recent debates over private ownership of prisons, which recently was countermanded at the federal level at least.  You also probably wouldn’t want Air Force One owned by the private sector, though you do want it to be designed and produced by the private sector.  This paper helped produce a framework for understanding the reasons why.

Hart’s 1979 piece on shareholder unanimity asks the important theory question of whether all shareholders will desire that firms maximize profits if markets are incomplete and some firm shares also serves secondary “insurance” purposes of helping protect against adverse states of the world.  For instance, say there is no insurance market in wheat.  You might use the shares of a wheat-producing firm for that purpose, and desire, for insurance purposes that the value of the firm covary with the value of wheat in ways that differ from simple firm profit-maximization.  The upshot of this literature is that firm profit maximization is not as simple or as self-evident an assumption as people used to think.

By the way, here are the two Laureates together, on “A Theory of Firm Scope.”  Here is their long, joint survey on theory of contracts.

Congratulations to Oliver Hart!

Oliver Hart and Bengt Holmstrom win the Nobel Prize

Hey, they announced it early this year!  Good thing I got up.  I’ll be revising a few (separate) posts throughout the morning, they will start out small and grow, so keep on hitting refresh.

These are theory choices in Industrial Organization, two very famous, well-deserving economists at the top of the field.  They focused on “theory of the firm,” internal organization, incentives,, and principal-agent problems.  More to come!

Here is the announcement.  After Jean Tirole two years ago, I wasn’t expecting another IO prize so soon…

Who will win the Nobel Prize in Economics this coming Monday?

I’ve never once nailed the timing, but I have two predictions.

The first is William Baumol, who is I believe ninety-four years old.  His cost-disease hypothesis is very important for understanding the productivity slowdown, see this recent empirical update.  Oddly, the hypothesis is most likely false for the sector where Baumol pushed it hardest — music and the arts.

Baumol has many other contributions, but the next most significant is probably his theory of contestable markets, plus his writings on entrepreneurship.

The other option is a joint prize for environmental economics, perhaps to William Nordhaus, Partha Dasgupta, and Martin Weitzman.  A prize in that direction is long overdue.

The “Web of Science” predicts Lazear, Blanchard, or Marc Melitz, based on citation counts.  Other reasonable possibilities include Robert Barro, Paul Romer, Banerjee and Duflo and Kremer (joint?), David Hendry, Diamond and Dybvig, and Bernanke, Woodford, and Svensson, arguably joint.  I still am of the opinion that Martin Feldstein is deserving, don’t forget he did empirical public finance, was a pioneer in health care economics, and built the NBER.  For a dark horse pick, how about Joseph Newhouse (RCTs and the Rand health care study)?

There are other options — what is your prediction?

Satoshi Nakamoto Nominated for Nobel Prize

Bhagwan Chowdhry, a professor of finance at UCLA, has nominated Satoshi Nakamoto, the creator of Bitcoin, for a Nobel prize in economics. It’s an excellent choice. Nakamoto made a fundamental breakthrough that combined cryptography and a distributed database to create the first decentralized cryptocurrency. Moreover, Nakamoto implemented his theoretical breakthrough to create a working cryptocurrency with real benefits to potentially billions of consumers.

Chowdry writes:

The invention of bitcoin — a digital currency — is nothing short of revolutionary….It offers many advantages over both physical and paper currencies. It is secure, relying on almost unbreakable cryptographic code, can be divided into millions of smaller sub-units, and can be transferred securely and nearly instantaneously from one person to any other person in the world with access to internet bypassing governments, central banks and financial intermediaries such as Visa, Mastercard, Paypal or commercial banks eliminating time delays and transactions costs.

But beyond demonstrating the possibility of creating a reliable digital currency, Satoshi Nakamoto’s Bitcoin Protocol has spawned exciting innovations in the FinTech space by showing how many financial contracts — not just currencies — can be digitized, securely verified and stored, and transferred instantaneously from one party to another.

…Not only will Satoshi Nakamoto’s contribution change the way we think about money, it is likely to upend the role central banks play in conducting monetary policy, destroy high-cost money transfer services such as Western Union, eliminate the 2-4% transactions tax imposed by intermediaries such as Visa, MasterCard and Paypal, eliminate the time-consuming and expensive notary and escrow services and indeed transform the landscape of legal contracts completely. Many industries such as Banking, Finance, Law will see a big upheaval. The consumers will be big beneficiaries and indeed the poor and marginal sections of the society will reap the benefits of financial and social inclusion in the coming decades. I can barely think of another innovation in Economic and Finance in the last several decades whose influence surpasses the welfare increases that will be engendered by Satoshi Nakamoto’s brilliant, path-breaking invention. That is why I am nominating him for the Nobel Prize in Economics.

Since no one knows who Nakamoto is it might seem difficult to award him a prize but Chowdry notes that bitcoin itself provides a solution:

The Nobel committee can easily buy bitcoins for the award money from any reputed online Bitcoin exchange and transfer it to him instantaneously. A very early bitcoin transaction suggests that the bitcoin address 1HLoD9E4SDFFPDiYfNYnkBLQ85Y51J3Zb1 likely belongs to him. Of course, he could easily and verifiably let the committee know which address he wants the money to be transferred to.

Angus Deaton wins the Nobel

Angus Deaton of Princeton University wins the Nobel prize. Working with the World Bank, Deaton has played a huge role in expanding data in developing countries. When you read that world poverty has fallen below 10% for the first time ever and you want to know how we know— the answer is Deaton’s work on household surveys, data collection and welfare measurement. I see Deaton’s major contribution as understanding and measuring world poverty.

Measuring welfare sounds simple but doing it right isn’t easy. How do you compare the standard of living in two different countries? Suppose you simply convert incomes using exchange rates. Sorry, that doesn’t work. Not all goods are traded so exchange rates tend to reflect the prices of tradable goods but a large share of consumption is on hard-to-trade services. The Balassa-Samuelson effect tells us that services will tend to be cheaper in poorer countries (I always get a haircut when in a poor country but I don’t expect to get a great deal on electronics). As a result, comparing standards of living using exchange rates will suggest that developing countries are poorer than they actually are. A second problem is the cheese problem. Americans consume a lot of cheese, the Chinese don’t. Is this because the Chinese are too poor to consume cheese or because tastes differ? How you answer this question makes a difference for understanding welfare. A third problem is the warring supermarkets problem. Two supermarkets each claim that they have the lowest prices and they are both right! How is this possible? Consumers at supermarket A buy more of what is cheap at A and less of what is expensive at A and vice-versa for B. Thus, it would cost more to buy the A basket at store B and it would also cost more to buy the B basket at store A! So which supermarket is better? Comparing standards of living across countries isn’t easy and then you want to make these comparisons consistently over time as well! Deaton, working especially with the World Bank, helped to construct price indices for all countries that measure goods and services and he showed how to use these to make theoretically appropriate comparisons of welfare. Deaton’s presidential address to the American Economic Association in 2010 covers many of these issues.

I see Deaton’s work on world poverty as a tour de force, he made advances in theory, he joined with others to take the theory to the field to make measurements and he used the measurements to draw attention to important issues in the world.

Earlier in his career, Deaton developed tools to bring theory to data on consumption. A key contributions is the Almost Ideal Demand System. We all know that demand curves slope down which means that a fall in the price of the good in question increases the quantity demanded but in fact economic theory says that the demand for good X depends not just on the price of good X but at least potentially on the prices of all other goods. If we want to estimate how a change in policy will influence people’s choices we need to allow demand curves to interact in potentially many ways but we still want to constrain those reactions according to economic theory. In addition, economic theory tells us that an individual’s demand curve slopes down but it doesn’t necessarily imply that the aggregation of individual demand curves must slope down. Aggregation is tricky! The Almost Ideal Demand system, due initially to Deaton and Muellbauer, in 1980 and further developed since then shows how we can estimate demand systems on aggregates of consumers while still preserving and testing the constraints of economic theory.

The study of consumption leads naturally to the study of savings, consumption in future periods. Here we have Keynes’s famous propensity to consume theory (consumption is a fraction of current income), Milton Friedman’s permanent income hypothesis (consumption is a fraction of estimated lifetime income), Modigliani’s Life Cycle Hypothesis (borrow young, save when middle aged, dissave when old). Robert Hall, building on the work of Ramsey, showed in the 1970s that rational expectations implies the famous Euler equation that bedevils graduate students, which shows that suitably discounted changes in marginal utilities should follow a random walk. Deaton played a big role in testing the new theories, mostly finding them wanting.

Deaton’s book, The Great Escape, on growth, health and inequality is accessible and a good read. A controversial aspect of this work is that Deaton falls squarely into the Easterly camp (Deaton’s review of Tyranny of Experts is here) in thinking that foreign aid has probably done more harm than good.

Here is Deaton on foreign aid:

Unfortunately, the world’s rich countries currently are making things worse. Foreign aid – transfers from rich countries to poor countries – has much to its credit, particularly in terms of health care, with many people alive today who would otherwise be dead. But foreign aid also undermines the development of local state capacity.

This is most obvious in countries – mostly in Africa – where the government receives aid directly and aid flows are large relative to fiscal expenditure (often more than half the total). Such governments need no contract with their citizens, no parliament, and no tax-collection system. If they are accountable to anyone, it is to the donors; but even this fails in practice, because the donors, under pressure from their own citizens (who rightly want to help the poor), need to disburse money just as much as poor-country governments need to receive it, if not more so.

What about bypassing governments and giving aid directly to the poor? Certainly, the immediate effects are likely to be better, especially in countries where little government-to-government aid actually reaches the poor. And it would take an astonishingly small sum of money – about 15 US cents a day from each adult in the rich world – to bring everyone up to at least the destitution line of a dollar a day.

Yet this is no solution. Poor people need government to lead better lives; taking government out of the loop might improve things in the short run, but it would leave unsolved the underlying problem. Poor countries cannot forever have their health services run from abroad. Aid undermines what poor people need most: an effective government that works with them for today and tomorrow.

One thing that we can do is to agitate for our own governments to stop doing those things that make it harder for poor countries to stop being poor. Reducing aid is one, but so is limiting the arms trade, improving rich-country trade and subsidy policies, providing technical advice that is not tied to aid, and developing better drugs for diseases that do not affect rich people. We cannot help the poor by making their already-weak governments even weaker.

Here is Tyler’s post on Deaton.

Addendum: Chris Blattman offers a very good perspective and appreciation.

The Economics Nobel Prize winner is Angus Deaton

A brilliant selection.  Deaton works closely with numbers, and his preferred topics are consumption, poverty, and welfare.  “Understanding what economic progress really means” I would describe as his core contribution, and analyzing development from the starting point of consumption rather than income is part of his vision.  That includes looking at calories, life expectancy, health, and education as part of living standards in a fundamental way.  I think of this as a prize about empirics, the importance of economic development, and indirectly a prize about economic history.

Think of Deaton as an economist who looks more closely at what poor households consume to get a better sense of their living standards and possible paths for economic development.  He truly, deeply understands the implications of economic growth, the benefits of modernity, and political economy.  Here is a very good non-technical account of his work on measuring poverty (pdf), one of the best introductions to his thought.

He brought a good deal of methodological individualism to the field of consumption studies, most of all by using household surveys more than macroeconomic data.

I think of this as a prize for “a whole body of work” rather than for one or two key papers.  David Leonhardt has a good NYT summary of some his work and its deep underlying optimism about the situation of the poor in the global economy.

Here is the popular version of the Committee statement, here is the more detailed version (pdf), an excellent overview.

Deaton was born in Scotland but has taught at Princeton for some time.  Here is Deaton on Wikipedia.  Here is Deaton’s home page.  Here are some recent working papers, he even has published in Review of Austrian Economics, an interesting review of Bill Easterly on experts.  Here are previous MR mentions of Deaton, there are many of them.  Here is Deaton on Google Scholar.  Here is a Russ Roberts EconTalk with Angus Deaton.  I think of Deaton as someone who is relatively willing to share himself with the world, let’s hope the Prize doesn’t ruin that openness.  Here is 21 minutes of Angus on YouTube, on his core ideas.

He is married to Princeton economist Anne Case, a notable scholar in her own right and sometimes a co-author with Deaton.  Here are their co-authored papers, many dealing with South Africa.

Deaton has long had a special working relationship with India and South Africa.  Here are his key pieces on measuring poverty and poverty reduction in India.  Here is his work on the Indian health survey.  Here is his 2010 AER piece on how to measure poverty globally in a consistent manner, by the way he suggests that asking people should be part of the answer.

He also has written on gender discrimination within the family in developing nations.  Some of his work has helped direct our attention to the viability of cash transfers as a way of fighting poverty.

At first, say circa 1980, he was known for his work in developing Almost Ideal Demand Systems for analyzing consumer expenditures; much of this early work was with Muellbauer.  That made a big splash, but it was more of a theoretical and technical advance than what was to follow.  One message was that studies based on the idea of a “representative consumer” were likely to prove misleading.

It is interesting to note the trajectory of his career, as Alex noted on Twitter.  He first did theory, then filled in the numbers and did empirics, applying the theory.  Eventually he took theory + empirics and used it to tackle some of the big issues of poverty and development.

Here is his long survey piece on foreign aid and growth.  He favors the move away from project evaluation, is skeptical of instrumental variable methods, and believes that RCTs need to be supplemented with a better theoretical understanding of mechanisms.  He knows a lot about many, many topics.

I do not know him, but he is described by many as a colorful character.  Dani Rodrik has strong praise for Deaton as a teacher.

Here are short, popular essays by Angus Deaton; you can call that the “what he really thinks page.”  He is critical of the Republican war against ACA and connects that topic to Downton Abbey.  He argues for regional price indices for the United States.  He discusses American inequality and why it is often ignored as an issue.  He warns against the creeping regulation of science.  And he considers why the Stern report had a greater impact in the UK than in America.

I very much liked Deaton’s recent book The Great Escape, which focuses on how modernity revolutionized standards for consumption.

This award is no surprise at all and he has been on the short list for a while.  Is it a slight surprise that Deaton won this prize on his own?  Many thought he would be paired with Anthony Atkinson, but I see Deaton as worthy of a stand-alone prize and Atkinson’s chance has not passed him by.  In any case, Tirole was a stand-alone prize too, so maybe in that regard there has been a shift in the Swedish regime.

Last but not least here is Alex’s post on Deaton.

Who will win the economics Nobel Prize this year?

Diane Coyle mentions some possible picks:

Environmental economics: Partha Dasgupta, William Nordhaus

Update: Twitter folks strongly recommend adding Martin Weitzman in this category.

Growth: Paul Romer, Robert Barro

Inequality: Anthony Atkinson, Angus Deaton

Innovation (and much else): Will Baumol (now 93!)

Econometrics: David Hendry

All good guesses.  I’ll add Diamond and Dybvig for banking, and possibly an early grant to Banerjee, Duflo, and Kremer for development and RCTs.  That would make economics look scientific, for a year at least.  I expect Bernanke, Woodford, and Svensson to get a prize as well for monetary economics, although probably not right now.  It is too close to Bernanke’s memoir and Svensson’s tenure at the Swedish central bank.

Here is a WSJ list.  What do you think?  Since I’ve never once been right about a particular year, trying to pick someone would only curse them.  The award will come this Monday of course.

Stanford is the top producer of Nobel Laureates in this century

And that is by a clear margin.  Columbia is number two.  Harvard is number eleven.  UCSB > MIT.  None for Oxford.

The list is here, excluding literature and peace prizes.

As for countries, the United States is a very clear number one and the UK is number two.  Other than Japan, Asia barely has any at all.

The pointer is from Michelle Dawson.  Here is my previous post on Stanford.