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COMMENTARY: GET REAL--AND WIN A NOBEL PRIZE
Economists are rarely lauded for being useful. Yet in large part that is why the 1997 Nobel Memorial Prize in Economic Science was given to Robert C. Merton of the Harvard business school and Myron S. Scholes, a professor emeritus at Stanford's Graduate School of Business. Their method, developed with the late Fischer Black, for measuring the value of a stock option--which allows an investor to buy or sell a stock at a fixed price--was a theoretical tour de force, solving a problem which had puzzled analysts for decades.
But equally important, the Black-Scholes option pricing rule, as it was called, was practical enough to be adopted by traders. (Black died in 1995, and the Nobel prize is not awarded posthumously.) Because the method could be used to price not just options but more complicated instruments as well, it made possible thriving markets in financial derivatives such as stock-index options. "Such rapid and widespread application of a theoretical result was new to economics," says the Nobel announcement.
The widespread use of the option pricing rule only emphasizes the vitality of financial economics compared with mainstream economics. This is the second Nobel prize awarded in recent years to financial economists. The previous one, in 1990, went to Harry M. Markowitz, Merton H. Miller, and William F. Sharpe for their work on portfolio diversification and efficient capital markets, which helped create today's mutual-fund industry.
LITTLE BOASTING. Mainstream economists have few such concrete contributions to boast about. Instead, most branches of economics have tended to lean away from the idea of being useful in favor of theoretical elegance. Take macroeconomic forecasting. Most businesses and ordinary people care deeply about whether the economy is likely to continue booming over the next year or if it may slide into recession. Indeed, these questions are the main focus of the public's interest in economics. Yet over the past 15 years, there has been very little academic work devoted to improving macro forecasts.
Financial economics, despite its demonstrable achievements--or maybe because of them--is still viewed as peripheral to basic economics. N. Gregory Mankiw's new economic-principles textbook--which epitomizes the mainstream view--mentions the stock market only in passing. The achievements of financial economists, including portfolio diversification and asset pricing, receive no attention in the textbook at all, even though Mankiw himself has done work in financial economics. (Full disclosure: The most recent edition of the economics textbook by Paul A. Samuelson and William D. Nordhaus, which I helped revise, does mention financial economics, but only in a short appendix.)
To be sure, there are many economists who are interested in the practical applications of their work. The idea of using tradeable pollution credits to help control noxious emissions without inflicting excessive costs on the economy was championed by economists. And the heated academic debate a few years ago over the employment impact of the minimum wage helped clarify some important policy issues. One set of economists argued that a minimum wage increase would destroy jobs, while another argued that employment would go up. The eventual consensus was that a small increase wouldn't make much of a difference in either direction--which actually made it easier for Congress to pass a minimum wage increase in 1996.
But increasingly, mainstream economists are failing the market test. The recent annual meeting of the National Association for Business Economics devoted several sessions to job switching and finding new careers, a sure sign that businesses are continuing their long-term trend of shedding economists. And economists have found themselves more and more marginalized within the Clinton White House.
If the decisions of the Nobel committee are any guide, it may be time for mainstream economists to start thinking a little more like financial economists--to be a little more practical and a little less arrogant. Usefulness is not the only value, but it's a good start.By Michael J. Mandel