The Fourth Member of a Great Quartet

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Nobel prizes in economics can be classified as either history prizes or museum prizes.  History prizes identify major turning points in the way that economic problems are conceptualized. Often their award makes news. Museum prizes are more like exhibits or installations. They are designed to showcase technical economics’ relevance to one problem or another, and tell something of how the community has worked together to address it.

The prize this year – to Peter Diamond, 70, of the Massachusetts Institute of Technology; Dale Mortensen, 71, of Northwestern University; and Christopher Pissarides (Pissa-ree’-deez), 62, of the London School of Economics, for their work on search – is a museum prize.

The story on its surface is the traditional linear one. Diamond does the high theory, beginning with a famous 1971 paper, “A Model of Price Adjustment,” demonstrating that search costs (“frictions”) can produce unemployment. Mortensen, already investigating the microeconomics of job search, brings a crucial tool (a Poisson process, in this case, of changes in the job-contracting environment). Diamond, who has been thinking about the intersection of law and economics, is stimulated to begin working towards a second highly-influential paper, “Aggregate Demand Management in Search Equilibrium,” published in 1982.

The relative “thickness” of various labor markets (or lack thereof) becomes a key consideration. If congestion among the unemployed is a problem, perhaps unemployment benefits should be set a little higher, to thin out the crowds jumping at the first job offer. Pissarides, meanwhile, has joined the hunt, and by 1985 has taken the first step towards a coherent search theoretical analysis of links among unemployment, vacancies and real wages.

Mortensen and Passarides join forces to publish “Job Creation and Job Destruction in the Theory of Unemployment” in 1994. The newly named Diamond-Mortensen-Pissarides model presents a picture of how firms and workers make joint decisions about when to expand and when to contract; how the business cycle may disrupt the process; and how hiring and firing costs, minimum wage laws, taxes and unemployment benefits may interact. Empirical work flourishes, while Diamond, the pre-eminent theorist of search, has long since turned his attention to other matters.

Look a little deeper, however, and the prize this year is obviously a compromise between theorists among the prize-givers and the more applied labor economists. It therefore delivers more than one good lesson. The subject for today is Peter Diamond.

Diamond is in the news this week mainly because the White House last month resubmitted to Congress his nomination as governor of the Federal Reserve Board. The appointment was shelved last summer by Sen. Richard Shelby (R-Alabama), apparently (according to Catherine Rampell of The New York Times) in retaliation for the Democratic majority’s earlier unwillingness to confirm the re-appointment of Randall Kroszner to a full 14-year term (Kroszner returned in January to the Booth School of Business of the University of Chicago). This time Diamond’s nomination is expected to be confirmed, notwithstanding much joking about “foreign influence” brought to bear on Congress, the result of the usual behind-the-scenes barter for some similar courtesy to be named later.

More to the point is the fact that Diamond (b. 1940) is the fourth and final member of the MIT quartet that includes Paul Samuelson (b. 1915), Franco Modigliani (b. 1918), and Robert Solow (b. 1924), to be honored by the Nobel Foundation for its contributions to macroeconomics.  Plenty of other MIT economists made their marks. Its roster of Nobel prizes include finance professor Robert Merton, econometrician Daniel McFadden, who was hired in 1977 after future laureate Robert Engle was passed over for tenure (Engle departed for the University of California at San Diego and, after fourteen years McFadden returned to California’s Berkeley campus), game theorist Eric Maskin, trade theorist Paul Krugman – thirteen in all, if  you include those who did their graduate work there, Lawrence Klein, Robert Mundell, George Akerlof and Joseph Stiglitz.

But it was the Samuelson quartet that had an outsize influence in theoretical macroeconomics in the first 35 years after World War II – the mysterious trade-off among unemployment and inflation, financial deregulation, free trade, government sponsorship of basic science, to name only the most obvious struts. They also created the template by which specialists in economic policy are trained. (James Tobin, Harvard trained, who spent fifty years at Yale was an ex officio member.)

Diamond, who had taken a class with mathematical economist Gerard Debreu while still a college senior at Yale, typically wrote a higher mathematical style than the others, but otherwise he shared their passion for generality, policy relevance, and fairness. George Mason University professor Tyler Cowen, a libertarian, the other day described the approach as “quite technocratic – solve and advise.”  Steven Levitt, of the University of Chicago, recalled the experience of reading Peter Diamond — “He wrote the kind of papers that I would have to read four or five times to get a handle on what he was doing, and even then, I couldn’t understand it all” — and related a story that nicely illustrated the difference between the innocent-eye approach of the author of Freakonomics and Diamond’s uncompromising precision. Diamond some years ago himself described his scientific life to good effect in this interview in Macroeconomic Dynamics.

The graceful Diamond labored for nearly forty years under the expectation that the prize one day would be his – and the knowledge that it might not come to pass. A seminal paper on optimal public debt, in 1965, established him as an expert in new approaches to the analysis of taxation and borrowing that were just then coming into vogue. In 1967, he wrote a second remarkable paper, on the effect of missing markets  for financial assets. The first of the search papers followed. Many observers feel the prize-givers should have recognized him with his long-time friend and research partner James Mirrlees for their work in the 1970s on the design of efficient tax policies.

Instead Mirrlees was paired with William Vickrey in 1996 for work on mechanisms designed to elicit private information (another museum prize), and Diamond’s chances seemed to recede after that.  This interview from Macroeconomic Dynamics gives a good look at a life in scientific economics whose single sentence contribution now boils down to this:  people have to search for their opportunities. He has been a member of the National Academy of Science since 1984.

Since then, Diamond has devoted more and more time to economic policy. Having worked in Kenya and Israel as a young man, he began traveling regularly to China to consult on its developing national pension system.  He became an influential student of the US Social Security System and in 2004 wrote, with Peter Orszag, Saving Social Security: A Balanced Approach. He was perhaps the first to suggest, in 1991, that the Federal Reserve System was an appropriate model for the oversight of health care in the United States. It was this wide familiarity with the practical details on medical, savings and retirement systems, combined with a command of their inner logic, which so suits him to the job as a governor of the Fed.

What finally brought Diamond the Nobel award, however, was the ingenuity of its curators, who found a way to bring him into the charmed circle of laureates by pairing him with the progenitors of a highly practical investigation. The gain is substantial: like most good prizes, the economics Nobel is, to an unappreciated extent, the creature of its recipients, who are privileged to nominate their successors without being asked. Diamond now becomes a part of that innermost conversation about where economics has been and where it is going.. Mortensen and Pissarides are no less interesting for being craftsmen of the applied research rather than master theorists. More on them in December.

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The results of the Harvard pool on the economics prize shows that seven people put $1 down on Diamond, meaning that 4.2 percent of the $165 that was wagered was riding on him. He ranked in the middle among the other candidates in the field. One canny (or well-informed) investor hazarded a buck each on Pissarides and Diamond, but no one picked Mortensen. Thus security once again was pretty good and the suspense remained until the curtain went up.

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Lionel McKenzie, of the University of Rochester, died last week at 91.  He was, as Harvard University’s Jerry Green said, “one of the great leaders in the field of economics in the ’50s, ’60s and on into the ’70s.” He was also, as Duke’s E. Roy Weintraub noted, the author of the most widely-used proof of the existence of general equilibrium: “Every economics graduate student today has to learn that proof.”

He was also an exemplar of economic science on its very best behavior. Aced out in 1953 of a share in an eventual Nobel prize by an ambitious competitor (last paragraph), he never complained. In the mid-1960s, he declined Stanford’s offer to replace Kenneth Arrow and instead remained at out-of-the-way Rochester to turn its department to a finishing school for a steady stream of deep and original economists over the next thirty years.