The University of Chicago Magazine: December 2001, Features

Wealth of notions
>> Finally, 22 economists whose ideas have at least one point in common: they all won the Nobel Prize. Here, in translation, are the theories that made Chicago famous.

MAROON IN THEIR BLOOD
Closer to the central core are ten Nobelists who were graduates of the College and/or the Social Sciences Division (ten of the 22 economics laureates have U of C degrees, including four from the College; three earned both their undergraduate and graduate degrees from Chicago) or were on the faculty or in research positions for a substantial length of time. Their work reflects Chicago's approach, and in many instances they were honored implicitly for contributions they made while on the quadrangles.

Paul A. Samuelson, AB'35, has been a recognized name in economics for a half century. Born in Gary, Indiana, he attended Hyde Park High School and the College but then took a left turn on Interstate 80 and has spent the rest of his career in Cambridge, Massachusetts, as a graduate student at Harvard and on the MIT faculty. He was honored in 1970 "for the scientific work through which he has developed static and dynamic economic theory and actively contributed to raising the level of analysis in economic science." Simply put, although he wasn't the first economist to use quantitative tools, Samuelson dramatically upped the level of mathematical and analytical sophistication, a path the discipline has followed ever since. His first major publication, Foundations of Economic Analysis (1947), promulgates that theoretical rigor and remains a classic.

He is also associated with Keynesian economics and its emphasis on fiscal policy-active manipulation of federal government spending and taxes to achieve full employment, contain inflationary pressure, and promote economic growth. Needless to say, these public-policy prescriptions, which he brought to the Kennedy administration in the early 1960s, do not sit well with most Chicago macroeconomists.

Samuelson is probably best known, however, for his introductory text, Economics, first published in 1948 and now coauthored by William Nordhaus at Yale, through which millions of undergraduates, including me, were introduced to the dismal science.

Political and economic opposites, Friedrich August von Hayek (1899-1992), a professor in the Committee on Social Thought (1950-64), and Sweden's Gunnar Myrdal shared the 1974 prize "for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena." Monetary economist Hayek's contributions centered on the role of money, credit, interest rates, and capital in business cycles, as well as the efficiency of economic systems.

Hayek's criticism of central economic planning, which he viewed as inefficient because of what a later Chicago laureate, Ronald Coase, termed "transactions costs," was consistent with his views that economic and political freedoms are inexorably linked, and with the high value he placed on individualism and liberty. A staunch defender of the free market and a rejecter of socialism (and Keynesian economics as well), he lived long enough to witness the collapse of the Soviet Union and other command economies in Eastern Europe.

The University of Chicago Press published both his most popular book, The Road to Serfdom (1944), and what is considered his most important volume, The Constitution of Liberty (1960), written at Chicago.

Tjalling C. Koopmans (1910-86) shared the 1975 prize with Russian economist Leonid Kantorovich. Koopmans, a research associate in economics in the mid-1940s, was from 1948 until 1955 a professor and director of research for the Cowles Commission. Founded in 1932 and based at Chicago from 1939 until 1955, the commission worked to promote research in forecasting techniques and quantitative and mathematical economics and to encourage work in econometrics.

Koopmans and Kantorovich were recognized for their "contributions to the theory of optimum allocation of resources." Together the two economists, one from a market system and one from a society that favored central planning, studied the relationship between inputs and outputs in production processes to answer basic economic questions of what goods should be produced, how scarce resources can be used most efficiently when there are alternative production methods available, and the distribution of that output between the present and the future. Koopmans advanced our understanding of how those decisions are made, the value judgments behind them (sometimes referred to as the normative theory of resource allocation), and the relationship between inputs and outputs in an economy.

A mathematician who switched to physics, Koopmans was a government statistician during World War II and a leading Cowles econometrician. He was intrigued by problems associated with efficiency in transportation systems, such as moving wood pulp from its source to newspaper plants or sequencing airplanes and routes, and managing large-scale operations, such as scheduling oil refinery operations. Today, spinoffs of his theories are key elements in operations research and linear programming-mathematical and computational techniques for solving economic, business, and engineering problems.

Herbert A. Simon, AB'36, PhD'43 (1916-2001), entered the College in 1933, intent on becoming a mathematical social scientist. His doctoral dissertation was on administrative decision making, and he held faculty appointments in political science, psychology, and information sciences. His 1978 prize for "pioneering research into the decision-making process within economic organizations" recognized his interdisciplinary work at the intersection of economics and psychology. Much of that work stemmed from Simon's participation in the Cowles Commission.

A popular view of classical economics-and one with which most economists still begin their modeling and explorations into business behavior-is that it assumes firms approach decision making in a fully informed, rational way, with the goal of maximizing profits. Starting with his 1947 classic, Administrative Behavior, Simon complicates that picture with notions such as "bounded rationality" and "satisficing" to suggest that constraints on information and complementary goals may lead firms and their managers to adjust their aspirations upward or downward in this imperfect world and thus settle for a comfortable, quick-and-easy outcome or profit level.

Gerard Debreu, the 1983 laureate "for having incorporated new analytical methods into economic theory and for his rigorous reformulation of the theory of general equilibrium," was at Chicago as a research associate with the Cowles Commission (1950-55). Debreu and 1972 laureate Kenneth Arrow are often considered in one breath, and his contributions are to some extent the result of his early-1950s collaboration with Arrow.

Debreu's individual recognition was for extending the mathematical rigor of welfare economics and demonstrating the stability of the overall general equilibrium system. In his 1959 volume Theory of Value and elsewhere, he was able to validate mathematically the logical consistency of Adam Smith's contention in The Wealth of Nations that when individual self-interest confronts the "invisible hand" in a decentralized market economy, it will lead to an efficient allocation of resources.

James M. Buchanan Jr., PhD'48, was honored in 1986 "for his development of the contractual and constitutional bases for the theory of economic and political decision-making." Beginning with The Calculus of Consent: Logical Foundations of Constitutional Democracy (1962, with Gordon Tullock) Buchanan's work combines economics and political science, and he is considered the founder of the public-choice school of economic thought.

The traditional raison d'être for government in a market economy, known as the public-interest theory, is to correct market imperfections (such as monopoly power or third-party effects-"externalities"), to enforce contracts, and to handle public goods (which could include some redistribution of income), and thereby make the system more efficient and more equitable.

By contrast, public-choice theory applies basic economic principles of costs, benefits, and incentives to the political marketplace, where citizens and firms demand things and politicians and bureaucrats supply them, to make themselves better off. Special interests use "rent seeking," logrolling, and pork-barrel legislation to divert potential surpluses to themselves. As a result, government participation reduces rather than increases efficiency-and government failure is more likely than market failure.

The 1989 Nobel prize was awarded to Trygve Haavelmo (1911-99), a research associate in economics in the 1940s and a visiting professor (1957-58), for "his clarification of the probability theory foundations of econometrics and his analyses of simultaneous economic structures." It was during his sojourn at Chicago with the Cowles Commission in the 1940s that he helped lay the foundations of modern econometrics-which his fellow Norwegian laureate, Ragnar Frisch (who won the prize in 1969), defined as the unification of statistics, economic theory, and mathematics.

Today econometrics and its statistical and mathematical cousin, regression analysis, are fundamental building blocks in business, economics, most other social sciences, and even in legal circles. But it was not always so. What Haavelmo did was to show that, based on probability theory, one could surmount problems associated with the lack of a natural ceteris paribus environment and the presence of interdependent relationships ("simultaneity" and "identification" problems) and thus apply statistical methods to economic data, test economic theories empirically, and draw statistical inferences. Lacking the physical scientist's laboratory to estimate, for example, how much smoking would be affected by an increase in the tax on cigarettes, the economist has to grapple with any concomitant "other things being equal" influences of education, income, and constraints on where one can light up; the ceteris is generally not paribus.

Harry M. Markowitz, PhB'47, AM'50, PhD'55, shared the 1990 prize with Merton Miller and William Sharpe "for their pioneering work in the theory of financial economics." With this Nobel, the first ever to business-school faculty, finance theory came in from the cold, taking its rightful place as an integral part of economics.

Despite the adage "Don't put all of your eggs in one basket," it took Markowitz to prove that diversifying one's assets is the correct strategy and to show how to make those allocations optimally. Markowitz's "portfolio theory," which he developed at Chicago in the early 1950s, analyzes how a household's or firm's wealth can be invested in assets that vary in terms of expected return and level of risk to produce a desired outcome.

Myron S. Scholes, MBA'64, PhD'70, who taught at the Graduate School of Business from 1973 until 1983, shared the 1997 prize with Robert C. Merton "for a new method to determine the value of derivatives," a class of financial instruments used to manage risk, especially due to unanticipated changes in price (or supply), and thus bring stability to markets, financial institutions, or production. Through a mathematical formula, Scholes and Merton provided the theoretical underpinnings of how one could assign a value to an "option," or the right-but not the requirement-to purchase an asset (or "put"), such as a stock, foreign currency, or a commodity, at a fixed price at some future date. If the stock rises in the meantime, you discard that option; if it goes down, you exercise the option. (A recent controversial example of this was the alleged purchases of United and American stock options by certain parties in the days leading up to the September 11 terrorist attacks; knowing in advance airline stocks would take a beating in response to fears about more hijackings and air travel safety would allow one to profit from the tragedy.)

The Chicago Board Options Exchange (CBOE), which began operations in 1973, functions largely on the basis of Scholes's and Merton's work. Farmers use derivatives when they sell on futures markets crops they have yet to plant. Options also ease international trade by letting trading partners hedge against fluctuations in exchange rates among currencies. And, in theory, they also make recessions less severe, helping economic agents to guard against unexpected changes in raw material prices and interest rates. New laureates also can apply the model, deciding whether to hedge in currency markets to protect themselves against an adverse fluctuation in the value of the Swedish kronor between the mid-October announcement and the December 10 check presentation.

There's a footnote to this prize. A 1974 rule change permits posthumous awarding of a prize only if the recipient named in October dies before the December ceremony (witness the 1996 case of Columbia economist William Vickrey, who won on a Tuesday and had a fatal heart attack while traveling to Boston three days later). If, however, Fischer Black, who taught in the GSB from 1971 to 1975, had survived his battle with cancer (he died in 1995), he would have undoubtedly shared the 1997 prize with Scholes and Merton. In fact, the mathematical equation that solved the option pricing problem is known as the Black-Scholes model.

Robert A. Mundell, a professor in economics (1966-71), was awarded the 1999 Nobel for work in two aspects of international trade and finance and macroeconomic theory. Although Mundell was teaching at Columbia in 1999, it's easy to defend the claim that his most important work was done at Chicago (his collection of papers, International Economics, was published in 1968), when he and colleagues Harry Johnson and Lloyd Metzler were three of the world's most recognized experts on international trade.

In work the award called his "analysis of monetary and fiscal policy under different exchange rate regimes," he compared stabilization policies-the use of monetary and fiscal policy to produce full employment, no inflation, and economic growth-when a nation's currency was fixed in value with other currencies to stabilization policies in a country in which the currency's value "floated" (as had been the case for most nations since the 1970s). One conclusion: monetary policy is more important, and fiscal policy far less important, under market-determined currency values, a conclusion that reinforces policy conclusions of other Chicago macroeconomists.

The second part of Mundell's Nobel recognized his "analysis of optimum currency areas," early research that extended the logic of a national currency-all U.S. states use the same monetary system, which reduces uncertainty and transactions costs in purchasing goods, traveling between the states, or extending loans across them-to the same advantages inherent in moving to a regional or international currency. In January 2002, 12 European nations move to precisely that concept: a common currency, the euro. (Not content to rest there, Mundell has now proposed moving to a world currency, presumably the U.S. dollar.)