The Nobel Prize in Economics & A Fed Nominee

It’s not often that an economist is nominated to the Fed, with Senate confirmation still up in the air, and the nominee becomes the co-recipient of the Nobel Prize for Economics. In fact, it’s never happened. It remains to be seen whether winning the Nobel helps or hurts in terms of joining the Fed. But there it is: MIT professor Peter Diamond is awaiting the Senate’s yea or nay. While he’s wondering if the government will be his next employer, he’s picked up what would appear to be a career-boosting prize. Diamond, along with Dale Mortensen (Northwestern University) and Christopher Pissarides (London School of Economics), yesterday were awarded the Nobel in economics for their research on the labor market.

The Nobel committee explained that the three economists were recognized for their analysis of so-called frictions in the job market. This trio’s work focuses on trying to bring perspective, if not answers, to a number of key questions, including: Why are there so many unemployed workers at times with relatively high amount of job openings? And, of course, the macro issue is pertinent as well, namely: How does economic policy alter the unemployment rate?

As the Nobel announcement’s press release explains,

This year’s Laureates have developed a theory which can be used to answer these questions. This theory is also applicable to markets other than the labor market. On many markets, buyers and sellers do not always make contact with one another immediately. This concerns, for example, employers who are looking for employees and workers who are trying to find jobs. Since the search process requires time and resources, it creates frictions in the market. On such search markets, the demands of some buyers will not be met, while some sellers cannot sell as much as they would wish. Simultaneously, there are both job vacancies and unemployment on the labor market. This year’s three Laureates have formulated a theoretical framework for search markets. Peter Diamond has analyzed the foundations of search markets. Dale Mortensen and Christopher Pissarides have expanded the theory and have applied it to the labor market. The Laureates’ models help us understand the ways in which unemployment, job vacancies, and wages are affected by regulation and economic policy. This may refer to benefit levels in unemployment insurance or rules in regard to hiring and firing. One conclusion is that more generous unemployment benefits give rise to higher unemployment and longer search times.

Additional background from the Nobel committee on the trio’s line of research advises:

According to a classical view of the market, buyers and sellers find one another immediately, without cost,and have perfect information about the prices of all goods and services. Prices are determined so that supply equals demand; there are no supply or demand surpluses and all resources are fully utilized. But this is not what happens in the real world. High costs are often associated with buyers’ difficulties in finding sellers, and vice versa. Even after they have located one another, the goods in question might not correspond to the buyers’ requirements. A buyer might regard a seller’s price as too high, or a seller might consider a buyer’s bid to be too low. Then no transaction will take place and both parties will continue to search elsewhere. In other words, the process of finding the right outcome is not without frictions. Such is the case, for example, on the labor market and the housing market, where searching and finding are essential features and where trade is characterized by pairwise matching of buyers and sellers.

As a graphical representation of one of the key issues studied by the three economists, consider the chart below, which is known as the Beveridge curve. It compares the jobless rate with the job vacancy rate. As the Nobel committee background report notes, “It has been known for a long time that the labor market fluctuates between situations of either high unemployment and few vacancies or low unemployment and many vacancies.”

Source: Royal Swedish Academy of Sciences

Why does the relationship in the chart above hold? One of the models created by this year’s Nobel winners in economics offers an explanation. Again quoting the background literature from the Nobel committee:

If unemployment and vacancies move in opposite directions, then changes can be regarded as reflecting variations in the demand for labor which occur over a business cycle. However, if unemployment and vacancies increase simultaneously, it is instead more natural to pursue an explanation in terms of changes in the performance of the labor market. One reason could be weaker matching efficiency, i.e., longer durations of unemployment in a given market situation. Another explanation could be more rapid structural changes that increase the rate at which firms lay off workers. Such developments on the labor market could be a sign that long-term unemployment will increase.

The labor market, of course, is front and center in the global economy at the moment, particularly in the mature economies of the U.S., Europe and Japan. In particular, the sluggish pace of job creation has sparked a fierce economic and political debate about what to do, if anything. Diamond says the U.S. needs a second stimulus package.

As for the theories of Diamond, et al., Alex Tabarrok of the Marginal Revolution blog says yesterday’s Nobel award “can be thought of as a prize for unemployment theory.” He continues: “A key breakthrough was to realize that the problem was not how to explain unemployment per se but rather how to explain hiring, firing, quits, vacancies and job search and to think of unemployment as the result of all of this underlying microeconomic behavior.”

It’s all quite topical at the moment, considering that the current U.S. unemployment rate of 9.6% has rarely been higher. And with few economists predicting a sharp drop anytime soon, the subject of the labor market could hardly be any more timely.

One might wonder if Diamond’s new claim to fame will help him win approval to the Fed. The stumbling block has been certain Senate Republicans, who argue that Diamond doesn’t have enough macro policy experience to warrant confirmation to the Fed. Leading the charge against Diamond is the senior Republican on the Banking Committee, Alabama Senator Richard Shelby. In late July, Shelby said that “Professor Diamond is a skilled economist and certainly an expert on tax policy and on the Social Security system. However, I do not believe he’s ready to be a member of the Federal Reserve Board. I do not believe that the current environment of uncertainty would benefit from monetary policy decisions made by board members who are learning on the job.”

Has Shelby changed his mind now that the nominee in question is a Nobel Prize winner? Not necessarily, or so the Senator’s comments yesterday suggest: “While the Nobel Prize for Economics is a significant recognition, the Royal Swedish Academy of Sciences does not determine who is qualified to serve on the board of governors of the Federal Reserve system.”

Diamond, it seems, is not only studying employment frictions, he may end up as the victim of the disease, albeit a particularly rare form a la Senate politics.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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