Nobel Prize for the times

This year's Nobel Prize in Economics could not have been given to a more appropriate set of people (my prediction notwithstanding!). The persistent high unemployment rates in the US during the Great Recession raises serious questions about classical theories which predict that the labor market will clear automatically (by way of wages falling thereby enabling labor supply to match with demand automatically).

The "austerians" have been attributing the persistently high unemployment rates to structural factors associated with changes in the economy in recent years, and feel that the high rates are only a manifestation of a "new normal". The implication of this is that any effort to boost demand by way of additional government spending would have no effect. In contrast, their opponents see this as a manifestation of weak demand and anemic investment environment. They therefore advocate more stimulus spending and monetary accommodation to enable effective utilization of idle manpower and encourage businesses to proceed with their regular investment decisions.

Professors Peter A Diamond of the Massachusetts Institute of Technology, Dale T. Mortensen of Northwestern University and Christopher A. Pissarides of the London School of Economics won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel "for their analysis of markets with search frictions" where buyers and sellers do not match themselves automatically. Specifically, they "spent decades trying to understand why it takes so long for people to find jobs, even in good economic times, and why so many people can be unemployed even when many jobs are available".

They argue that it takes time for unemployed workers to be matched with the proper opening, since neither people nor jobs nor employers are identical. These findings are relevant for markets with differentiated products — like labor and housing - which do not fit into the classic supply-demand equalizing paradigm. In these markets, "heterogeneous sellers confront heterogeneous buyers, and it takes time and effort to find appropriate matches".

On a broader canvas, their work is an important component of "search theory", which has been applied to many other areas, like money systems and venture capital markets. Labor economists talk about firing costs, family economists talk about divorce costs, and housing economists talk about shifting costs, all of which comes in the way of automatic market adjustments. Their findings also point to the possibility of unintended consequences like unemployment benefits ending up prolonging joblessness by making it less costly to be without work.

As NYT reports, Prof Diamond said that one of the implications of his work was the fact that more fiscal and monetary stimulus was probably necessary to speed up job growth, "The slower it happens, the more workers lose their skills and stop searching, and so the process goes more poorly after that". Rejecting the "new normal" unemployment rate hypothesis, Prof Diamond says, "Workers and employers will adapt to what will make the economy function. I see no reason why, once we get fully over this, we won’t go back to normal times".

Professor Mortensen argues in favor of additional measures to get credit functioning more normally, and in particular to make it easier for small businesses to get loans, were crucial to reducing unemployment, "From my perspective the problem right now is not the labor market. What’s happening in the labor market is a symptom of more complicated problems with the financial market".

In many respects, this prize may also be seen as the final triumph of Keynesianism itself. While Keynes had generically argued that economies need not automatically recover from a recession, this year's winners have shown that much the same applies to the labor market for varying reasons. Edward Glaeser who has this excellent summary of their research, also has the most appropriate tribute,

"Rarely has the prize committee been better able to match the honored work with the moment."

See Mostly Economics for a nice summary and and excellent graphical explanation by Econospeak of the Beveridge curve relationship and the difficulty of assessing any equilibrium unemployment rate.