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Economist Lars Peter Hansen Finds Fault with Economic Models

At a recent New York talk, University of Chicago economist and Nobel laureate Lars Peter Hansen called for policymakers to consider the unknown.

Counting up from zero, three is the first odd prime number. University of Chicago economist Lars Peter Hansen knows this on several levels.

For one, as an expert in econometrics, the geeky side of macroeconomics, he spends his days pondering how to coax numbers into revealing hidden economic trends. He also rounds out the trio of the 2013 recipients of the Nobel Memorial Prize in Economic Sciences, along with fellow University of Chicago professor Eugene Fama and Yale’s Robert Shiller. They were all recognized for, as the Royal Swedish Academy of Sciences puts it, “their empirical analysis of asset prices.” But while Fama and Shiller spar over the Efficient Market Hypothesis, Hansen’s chief hypothesis concerns the efficiency of economic models themselves. He argues that economic models are inherently uncertain because they depend upon unknown quantities.

Earlier this month Hansen took his message to Wall Street, whose devotion to models was partly to blame for the great financial crisis, in the eyes of some critics. On a balmy afternoon in Credit Suisse’s offices, across the street from Manhattan’s verdant Madison Square Park, Hansen spoke on a panel organized by the U of C’s Becker Friedman Institute — itself named for two Nobel econ laureates. What is certain, he told a crowd of 150, was that “models are always wrong in some sense; they are simplifications or abstractions.”

Academics and analysts debate over whether the present economy is in precrisis or postcrisis mode. Naming conventions aside, Hansen postulated, the economy is yielding “new sources of fluctuations in so-called uncertainty places.” He followed up that statement with a couple of questions that many in the audience — myself included — were asking ourselves: “What exactly does that mean? What is it that drives around that trade-off of risk and return in asset markets?” Hansen suggested that rather than trying to contain systemic risk, “we should be using a more general notion of systemic uncertainty” when formulating regulatory policy.

“The point I want to drive home is that maybe the best way to make policy is not to impose complex regulations,” such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, intended to contain risk, he says. “I think it’s better if we face up to the unknowns and acknowledge uncertainty.”

One factor he dubs an unknown is the outcome of the U.S. Federal Reserve’s recent monetary policy. Hansen said that much of the speculation over when the Fed will finally raise interest rates from the zero bound has centered on how monetary tightening will affect asset prices but not necessarily its effect on labor markets, a factor dependent on other unknowns. For example, convenient, easily accessible figures such as the unemployment rate might tell only part of the story. As Fed chair Janet Yellen has pointed out, the unemployment rate does not include part-time workers who want full-time employment or those who have given up on their job search.

Another lingering unknown is how the baby boomers’ collective move toward retirement will shake out on U.S. gross domestic product during the next 25 years — especially for social programs such as Medicare. “I don’t know why we’re not talking more seriously about delaying some of the benefits, phasing in changes that roll back benefits in a very gradual way,” said Hansen. “We need to do this now so people can plan.”

Hansen can get away with saying that on an academic panel — or on Wall Street. From a member of Congress, the comment might prove less popular. But Hansen should understand. After all, politics and human behavior are economic uncertainties.

Follow Anne Szustek on Twitter at @the59thStBridge.

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