Next Monday, October 12, the Royal Swedish Academy of Sciences will announce the winner of the 2020 Nobel Prize in Economics. As it is now traditional, the event is generating speculation, debate, and predictions among many of my economics colleagues. Gossip abounds, and betting activity is lively.
Let me refrain from guessing who will turn out to be the chosen one on Monday. The Academy’s selection criteria have been opaque, and history suggests that political considerations and fashion have played a significant role. Therefore, predicting Nobel winners is like buying tickets in a lottery with unknown probabilities.
Instead, I take this opportunity to reflect on who deserves to win the Nobel and, more generally, on what it is which makes some contributions (and not others) essential to our profession. In doing that, I will not only express my preferences and my (humble) opinion, but also state the central criterion for my ranking. I believe it is appropriate to name it the “Lucas Criterion” because, just like many other aspects of Economics, I was lucky to learn it from Robert Lucas Jr. [1]
It must have been more than two decades ago when, enjoying drinks after a Summer conference day at Northwestern (and one of the memorable soccer games between junior professors and tenured ones) when one of the younger participants posed the question of who would win the Nobel prize that year. The debate grew and eventually turned to the issue of who deserved the honor. At that point, Lucas (who was the strongest candidate then, and would win it the following year) said: “The prize should go to that economist who generates the most jobs in the profession”.
His dictum intrigued me and remained stuck in my memory: What did Lucas mean? With time, I have come to realize that Lucas was telling us a lot. A contribution worthy of a Nobel opens the door for many of us to explore it, to extend it, to translate it into actions, to teach it to future generations. In other words, the measure of the contribution’s importance is the creation of employment for us, economists.
A perfect example of the new Lucas Criterion is, of course, the work of Lucas himself. Think about how many jobs it directly created: how many economists have devoted ourselves to extend his theories, to estimate related models, to articulate its implications for macroeconomic and financial policy? And in somewhat less direct but no less important ways, let us think about the impact that Lucas’s ideas has had on the real world, through the application of economic policy and reforms.
Therefore, in thinking about who deserves the Nobel, my first consideration is who has made a fundamental contribution, in the sense of creating employment for other economists, in line with the Lucas Criterion. And, following the Criterion, some candidates emerge clearly.
For concreteness, and given that we are ad portas of another round of this ritual, I mention the case that seems strongest to me. A contribution that still waits for recognition with a Nobel is the modern theory of financial intermediation, whose cornerstone is the banking model of Douglas Diamond and Phil Dyvbig. [2] That model was the first to explain how, starting from plausible assumptions on economic fundamentals, banks or financial intermediaries emerge and have crucial features, especially in financing real credit and investments by raising demand deposits. The process involves a transformation of maturity of bank assets and liabilities (since demand deposits are short term obligations that banks use to fund long term loans) which, in the model, serves a beneficial social role (to deliver an efficient solution to the problem of insuring depositors against short term random liquidity needs, in the presence of asymmetric information). At the same time, the required maturity mismatch can result in other equilibria that are counterproductive, featuring bank runs and financial panics. In the theory of Diamond and Dybvig, such crises can be ruled out via a deposit insurance system or the presence of a lender of last resort.
The Diamond-Dyvbig model revolutionized the study of the financial sector and its interaction with the macroeconomy. Its impact on the profession is obvious. Numerous colleagues in Economics and Finance have devoted a major part of their research life to explore the theoretical aspects of the model, to understand its technical details, and to test its empirical validity. Its importance is such that, every time a new model appears including banks or financial intermediaries, the first question is how those banks relate to the Diamond-Dybvig model.[3]
In turn, much current analysis supporting supervision and regulation of banks and financial intermediaries is grounded on versions of Diamond-Dyvbig. And the most convincing explanations of recent financial crises, as well as the design of policies aiming at preventing similar episodes, are derived from that model. In fact, Diamond-Dyvbig has been virtually the only theoretical apparatus that allows us to start understanding the global financial crisis that began in 2007 and crested with the September 2008 Lehman Brothers failure. [4] In turn, that analysis furnished the conceptual justification for the forceful response of central banks around the world to the Covid-19 crisis, during which the financial sector has been surprisingly robust.
For all these reasons, any modern macroeconomist must study the Diamond-Dybvig model. More than that: many jobs in our profession (and, needless to say, in the world in general) would not exist if Diamond and Dybvig had not invented their model.
I guess that it is quite likely that Diamond and Dybvig will not win the Nobel prize this time around, as certainly there are other deserving candidates. On the other hand, the list is not long, especially if we adopt the new Lucas Criterion.
Post Scriptum. My friends César Martinelli and Gonzalo Pastor have challenged me to identify which Latin Americans should considered Nobel-worthy under the Lucas Criterion. Because of time and space, I only mention the two names that come to mind at once. The first one is obvious: our mentor and friend Guillermo Calvo. The second name is certain to be more controversial, but there it goes: Hernando de Soto.
[1] And, of course, I hope that the reader will not confuse the new Lucas Criterion with the Lucas Critique.
[2] The original paper is “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy Vol. 91, No. 3. (June 1983), pp. 401-419. Of course, the subsequent literature is gigantic.
[3] In fact, the so called “Third Generation” of exchange rate crises often starts from open economy models featuring DD banks. See Roberto Chang y Andrés Velasco, “A Model of Financial Crises in Emerging Markets,” Quarterly Journal of Economics, 116 (2001), 489-517
[4] See, for instance, Gary Gorton, “Information, Liquidity, and the (Ongoing) Panic of 2007,” American Economic Review, American Economic Association, vol. 99(2), 567-72, May 2009.