Models explain rigidity in European markets

3310 nobelwire
Feng Wu—The Tech File PhotoInstitute Professor Peter A. Diamond PhD ‘63 won the 2010 Nobel Prize for Economics yesterday, for his work on modeling the friction in markets. Diamond shares the prize with two co-winners, Dale T. Mortensen and

Peter A. Diamond PhD ’63, a nominee for a Federal Reserve Board position, and two collaborators were awarded the 2010 Nobel Memorial Prize in Economic Science on Monday for their work on markets where buyers and sellers have difficulty finding each other.

The work of the winners, Diamond of the Massachusetts Institute of Technology, Dale T. Mortensen of Northwestern University and Christopher A. Pissarides of the London School of Economics, is best known for its applications to the job market. The researchers spent decades trying to understand why it takes so long for people to find jobs, even in good economic times, and why so many people can be unemployed even when many jobs are available. Traditional economics, after all, would predict that wages should simply drop, helping the labor supply to meet labor demand automatically and sweeping jobless workers into whatever positions were immediately open.

These researchers’ explanation addresses the complications that come from searching for jobs and job candidates: It takes time for unemployed workers to be matched with the proper opening, since people are not identical, cookie-cutter units, and neither are jobs.

While all this may seem intuitive, in the 1970s it was considered quite radical. The resulting insights about how search costs can affect markets also helped revolutionize not only labor economics but fields like public finance and housing economics as well. The work is especially relevant today, as policy makers try to understand and combat the causes of stubbornly high unemployment in countries like the United States.

In a phone interview, Diamond, 70, said that one of the implications of his work was that more fiscal and monetary stimulus was probably necessary to speed job growth.

“The slower it happens, the more workers lose their skills and stop searching, and so the process goes more poorly after that,” Diamond said.

President Barack Obama nominated Diamond in April for a Fed board position, where he would serve under his former student, Ben S. Bernanke, the Fed chairman. But in August, under an obscure procedural rule, the Senate sent Diamond’s nomination back to the White House before starting its summer recess, and a senator questioned his experience.

Obama renominated Diamond for the Fed position Sept. 13. A hearing on his confirmation is still to come.

The work honored Monday also suggests that policies intended to help workers can have unintended consequences. Unemployment benefits, for example, can prolong joblessness by making it less costly to be without work.

“That’s a big controversy in the U.S. recently,” said Robert Shimer, an economics professor at the University of Chicago. “Most of these models suggest that even in a depressed economy, more generous unemployment benefits tend to raise the unemployment rate. Benefits are obviously good for the unemployed, but there are some clear tradeoffs.”

The models help explain why European labor markets tend to be much more rigid than U.S. ones, where people can move from job to job relatively easily, at least in good times.

“Many European countries put restrictions on the ability of firms to hire and fire,” said Lawrence F. Katz, a Harvard economist. “If you make it harder to hire and fire, then you end up with what’s called a sclerotic labor market, with less movement between jobs and more long-term unemployment.”

Europe’s struggles in the 1970s and 1980s with an underclass of chronically unemployed workers helped inspire Pissarides, 62, a Cyprus native, to study the search costs of labor markets in the first place, he said.

Monday’s announcement also played into current debates about the government’s role in addressing long-term unemployment and about whether the elevated unemployment levels today represent a “new normal.”

“I think the economy is very adaptive,” Diamond said in a news conference at MIT. “Workers and employers will adapt to what will make the economy function. I see no reason why, once we get fully over this, we won’t go back to normal times,” with more “normal” unemployment rates.

Mortensen, 71, of Northwestern, said additional measures to get credit functioning more normally, and in particular to make it easier for small businesses to get loans, were crucial to reducing unemployment.

“From my perspective the problem right now is not the labor market,” he said during a phone call with reporters. “What’s happening in the labor market is a symptom of more complicated problems with the financial market.”

The line of research begun by the three Nobel laureates is still active today. “Search theory” has been applied to many other areas, like money systems and venture capital markets — really, any market that can be considered heterogeneous.

“Which is most markets,” said Robert E. Hall, a Stanford economist, “except for maybe things like grain.”

Justin Wolfers, a University of Pennsylvania economist, has applied the theory in his own work on marriage and divorce, for example.

“Labor economists think about firing costs, and family economists think about divorce costs,” Wolfers said.

Just as restrictions on firing an employee make fewer workers available for new positions — and therefore make companies skittish about making too many changes to their work force — low divorce rates can be self-perpetuating. With divorces rare, unhappy spouses may think twice about getting a divorce themselves, since there would be so few eligible new mates available after the breakup.

The Nobel in economic science is awarded by the Royal Swedish Academy of Sciences and is not one of the original prizes created by Alfred Nobel. In addition to a medal and a diploma, the laureates collectively will receive 10 million Swedish kronor, or about $1.5 million.