More on Lars Peter Hansen’s Economic Research

by Amir Yaron, Professor of Finance, Wharton, University of Pennsylvania

Lars Peter Hansen could, in my mind, have won the Nobel in any one of the following three different categories: Econometrics—the statistical methodologies used to study economics; macro and specifically the modern dynamic consumption function; and asset pricing-–the one he was awarded the prize for. Lars Hansen is an intellectual giant who I had the great privilege to study under. My mother reminded me this week that after my first year in the Ph.D. program I already told her Lars Hansen will win the Nobel. I replied that was much easier than predicting returns. Working with Lars always felt what I envision it must have been to be at NASA—simply breaking frontiers. Hansen is an expert in dynamic models and has developed both theory and methods for evaluating and empirically assessing the link between the macro economy and financial markets.

A Classroom Instruction from Lars Peter Hansen

A Classroom Instruction from Lars Peter Hansen

Hansen’s most famous methodological contribution which is known as the Generalized Method of Moments (GMM), has changed completely the way empirical work is done. To simplify things, almost all economic problems involve an optimization in which marginal costs are equated to expected benefits (hence the importance of dynamics in his work).  Hansen’s contribution is in providing a relatively simple, clean, yet very general way to assess whether economic agents (e.g., firms, consumers, investors, governments) are appropriately equating the marginal costs to expected benefits.

In the first application of this method, Hansen used an asset pricing/investment problem: the costs are foregoing one dollar of consumption today while the expected benefits are consuming more in the future depending on the invested returns. The findings were that for the economy as a whole, and for a large class of returns, the marginal costs seem to be smaller than the expected marginal benefits when agents are rational and have reasonable attitudes toward risk. This suggested investments were relatively “a good deal”, a finding related to Shiller’s work and intimately related to the “Equity Premium Puzzle” a term coined by Rajnish Mehra and former Nobel Ed Prescott. Methodologically, this paper transformed the academic profession – it showcased how applicable GMM is. It is now used in almost every applied field of economics in academia as well as outside of it.

In the best of the Chicago economics tradition Lars Hansen mixes theory and data and covers multiple disciplines. He is the exemplary scientist who treats economics seriously‐‐  he poses theories, applies them to data, tests them, and in response to the results goes back to the drawing board. As an example, in the last decade or so Hansen and co‐author Tom Sargent (Nobel 2011) have refined an approach to the rational expectation paradigm. They focused on what’s called Knightian uncertainty–-a situation
where agents don’t completely know the environment they are operating within (e.g., recent crisis) and this induces them to behave in a different and cautious way. This work is related to decision theory work by Gilboa and Schmeidler (Tel Aviv University) and in a broad way, although methodologically very different, can also be linked to Shiller’s work on over and under reaction. This demonstrates Hansen’s great depth and breadth as a leading economist.

I am confident that I am not overconfident when saying more path‐breaking work by Lars Hansen is ahead of us.

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One Response to More on Lars Peter Hansen’s Economic Research

  1. I hope you agree that long ago Sims, Sargent and other macroeconomists moved well beyond ISLM models and even rational expectations. Unfortunately policy debates still rely on ad hoc corrections to ISLM models. Earlier today, when Sims was interviewed as part of the Prize announcement, he was asked about the relevance of his work for the ongoing policy debate. He politely answered that it would take too long to explain his work and to relate it to the ongoing policy debate. Indeed, the work of scholars at the frontier of macroeconomics is not something one would recommend bloggers, particularly journalists and other mercenaries of fraudulent clowns, to discuss. Let them entertain themselves discussing about what Keynes said and what Dernburg & McDougall’s ISLM model implies for policy making.

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