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Presentation Speech - The Sveriges Riksbank (Bank
of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel
KUNGL. VETENSKAPSAKADEMIEN THE ROYAL SWEDISH ACADEMY OF SCIENCES
11
October 1989
THIS YEAR'S LAUREATE IN ECONOMICS SHOWED HOW ECONOMIC THEORIES CAN
BE TESTED
The Royal Swedish Academy of Sciences has decided to award the
1989 Alfred Nobel Memorial Prize in Economic Sciences to
Professor Trygve Haavelmo, Oslo, Norway,
for his clarification of the probability theory foundations of
econometrics and his analyses of simultaneous economic structures.
Summary
This
year's prize in economic sciences is awarded to Trygve Haavelmo
for his fundamental contributions to econometrics.
During the 1930s, noteworthy attempts were made to test economic
theories empirically. The results of these attempts called attention
to two fundamental problems associated with the possibility of
testing economic theories. First, economic relations often refer to
large aggregates of individuals or firms. Theories regarding such
relations can never be expected to conform fully with available
data, even in thc absence of measurement errors. The difficult
question then is to determine what should be considered sufficiently
good, or bettcr conformity. Second, economists can seldom or never
carry out controlled experiments in the same way as natural
scientists. Available observations of market outcomes, etc., are
results of a multitude of different behavior and relations which
have mutually interacting effects. This gives rise to
interdependence problems, i.e., difficulties in using
observed data to identify, estimate, and test the underlying
relations in an unambiguous way.
In his dissertation from 1941 and a number of subsequent studies,
Trygve Haavelmo was able to show convincingly that both fundamental
problems could be solved if economic theories were formulated in
probabilistic terms. Mcthods used in mathematical statistics could
then be applied to draw stringent conclusions about underlying
relations from thc random sample of empirical observations.
Haavelrno demonstrated how these methods can be utilized to estimate
and test economic theories and use them in forecasting. He also
showed that misleading interpretations of individual relations due
to interdependence cannot be avoided unless all relations in a
theoretical model are estimated simultaneously.
Haavelmo's doctoral thesis had a swift and pathbreaking influence on
the development of econometrics. His probability theory research
prograrn attracted a number of outstanding economists - among them,
subsequent Nobel laureates such as Koopmans
and Klein.
This gave rise to extraordinarily rapid methodological development,
primarily during thc 1940s. The foundation of modern econometric
methods had thus been established
The Probability Theory Revolution in Econometrics
Econometric
research has been carried out since the beginning of this century.
Initially, U.S. economists such as Moore and Schultz worked on
econometric determination of supply and demand on individual
markets. During the 1930s, Tinbergen
and Haavelmo's own teacher, Ragnar
Frisch, made the first attempts to apply corresponding methods
to test various macrodynamic relations. These estimates touched on
several problems which Haavelmo later analyzed in his dissertation.
Prior to Haavelmo's thesis, researchers lacked a common conceptual
system for formulating, analyzing and solving econometric problems.
At the time, few econometric methods were based on probability
theory and therefore could not utilize statistical inference to draw
conclusions from data. To the extent that calculations contained any
random variations at all, they usually referred to measurement
errors in the variables. Simple statistical methods - mainly
regression analysis - were used in most instances, without any clear
probability theory assumptions whatsoever. During this period, most
prominent economists including Keynes - rejected more extensive use
of probability theory in empirical research on the grounds that, e.g.,
economic processes were irreversible. Many of the leading
econometricians of the day - such as Frisch - were also skeptical
about the possibility of applying statistical inference methods to
economic data.
In his dissertation, Haavelmo refuted these various objections and
showed that in order for economic theories to be testable,
probability theory formulation is not only a prerequisite, but also
extremely reasonable. Economists analyze results of millions of
decisions made by individuals and firms. According to Haavelmo, it
is unreasonable to believe that economists could ever
"fully" explain or predict such individual decisions on
the basis of necessarily simplified assumptions. Decisions are in
fact affected by individual characteristics and numerous temporary
conditions which change over time. Therefore, economists'
explanations of decisions always have to encompass a stochastic term
which summarizes these different kinds of "disturbances".
As economic theories in general do not refer to individual decisions
but are concerned with relations which comprise long sequences of
decisions and a multitude of decision-makers, there are frequent
opportunities to make relatively simple assumptions about the
probability distribution of these aggregate relations.
Haavelmo also demonstrated that by formulating theories in
probability theory terms, statistical inference methods could be
applied to estimate and test economic theories and use them in
forecasting. Most of the problems he dealt with and analyzed are
associated with interdependence in economic relations.
Interdependence Problems
In
economic life, every individual decision may be regarded as
affecting all other decisions through a chain of market relations.
This economic interdependence creates problems in empirical research
because an observed market outcome is the result of a large number
of simultaneous or previous decisions and behavioral relations.
Thus, an underlying relation can never be observed, as it were, in
isolation, but only as conditioned by a number of other simultaneous
relations and circumstances in the economy. As Haavelmo showed,
interdependence gives rise to difficulties in specifying,
identifying and estimating economic relations.
The difficulty of specifying economic explanatory models, lies in
choosing among numerous models or systems of relations which might
explain the observed market outcome. When the relations in the model
are interdependent, then a set of model equations can be used to
derive a multitude of other equation systems which produce the same
observable result. Haavelmo emphasized the importance of trying to
choose a set of relations which are each as "autonomous"
as possible, i.e., which are not affected by changes in other
parts of the system. For example, in order to determine the effect
of a decrease in household incomes, due to changes in fiscal policy,
on private consumption, then obviously the estimate of the
propensity to consume used in the computation should not be
conditioned by previous fiscal policy. The choice of autonomous
relations in explanatory models is primarily a matter of adequate
knowledge and intuition regarding the basic mechanisms of the
economy. However, Haavelmo also discussed the need for statistical
invariance tests and not too long ago, researchers succeeded in
developing a method whereby the autonomy in different relations can
be tested statistically.
The fact that many different types and forms of explanatory models
can explain observed data, also gives rise to an identification
problem. For example, if a theory is intended to explain the
observed relations between price and sales on a market, the
relations have to be aufficiently specified so as to be identifiable
as demand and supply relations, respectively, with some given form
of probability distribution. Haavelmo was the first to provide an
explicit mathematical formulation and solution of the identification
problem. Further development of identification criteria has been
based on his formulation.
Interdependence also creates what Haavelmo called simultaneity
problems in estimating models with several different structural
relations. Since the combined relations limit the possible
variations in the input variables, isolated estimates of individual
relations can be highly misleading. Using a probability theory
framework, Haavelmo provided a generally valid formulation and
method of measuring this bias in isolated estimates of individual
relations in an interdependent system. He also showed that the
problem could be avoided by using a method of simultaneous estimates
of interdependent models. Haavelmo's analysis of simultaneity
problems has had a decisive influence on later work with econometric
models.
From Econometrics to Economic Theory
Once
the foundation of probabilistic econometrics had been established,
Haavelmo's next important research effort involved attempts to
transform various components of economic theory so that the new
econometric methods would be applicable. According to Haavelmo, the
prerequisites for achieving this purpose were not only additional
assumptions about probability distributions, but also in many
instances a more dynamic theoretical formulation. There are two
areas in particular - investment theory and economic development
theory - where Haavelmo's approach has resulted in influential and
far-reaching contributions. In addition to these main lines of
research, Haavelmo's achievements include valuable contributions in
numerous areas - from analysis of macroeconomic fluctuations and
fiscal policy to price theory and the history of economic thought.
Major Publications
Haavelmo's
most influential study is his doctoral dissertation entitled, The
Probabilitv Approach in Econometrics , presented at Harvard
University in April 1941, although not published until 1944 as a
supplement to Econometrica. The argument in his thesis was
later extended and exemplified in numerous publications, among which
may be mentioned two articles in Econometrica: "The
Statistical Implications of a System of Simultancous Equations"
(1943) and "Statistical Analysis of the Demand for Food"
(1947, co-authored by M.A. Girshick).
Haavelmo's
early research on economic development theory is summarized in his
book entitled, A Study in the Theory of Economic Evolution
(1954). A corresponding resume of Haavelmo's contribution to
investment theory is given in A Studv in the Theory of Investment
(1960).
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