Lars Peter Hansen

Nobel 2013 | How can we deal with economic uncertainty?

When we think of our future, no matter how well we plan, we know it could turn out differently than how we imagined it. What we don’t know is how different it could be. This introduces a whole new level of insecurity, one that not only makes us feel fairly uncomfortable, but is also more difficult to grasp and conceptualize mathematically.

While we can’t know what we don’t know, economist Lars Peter Hansen has not only not shied away from this question, he has tried to understand its ambiguity. He acknowledged the pervasiveness of uncertainty in all aspects of our lives, particularly with regard to economic activity, and has pushed this incredibly complex and challenging matter to the forefront of economic modeling.

Lars Peter Hansen

Lars Peter Hansen

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, 2013

At a glance

Born: 1952, Urbana, Illinois, USA

Field: Econometrics, financial economics, macroeconomics

Prize-winning work: Empirical analysis of asset prices

Teaching style spiced-up by: Deadpan humor

Alternative career: Wanted to be a rock star

A new type of economic research

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Uncertainty is just one of many areas of economics in which Hansen’s contribution made significant waves. It allowed him to talk to all kind of economists, from financial to labor, and econometricians to macroeconomists. He not only talked, but also listened to these people, a trait that many of his colleagues find admirable. Hansen has a very unique way of looking at economic problems, which resulted in his invention of an econometric model called Generalized Method of Moments (GMM). GMM helped economic research take a huge step forward by allowing economists to investigate a single aspect of a complex model without having to specify every part. Although the example that Hansen worked on dealt with particular features of asset price data in financial markets, the method has been used across economic disciplines ever since. It also won him the Nobel Prize in 2013.

Uncertainty: ignore it or face it?

The French philosopher Voltaire once said “Doubt is unpleasant, but certainty is absurd.” This quote is dear to Hansen and he often uses it to illustrate the general public’s attitude towards uncertainty.

That doubt is unpleasant is the way many people think about uncertainty, it’s like wow, this is something I just want to avoid. But it’s out there and to pretend it’s not is even worse.

Hansen believes we need to convince people that there are sensible ways to think about decisions while facing all types of uncertainty and that they shouldn’t give up even when it’s complicated.

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Not knowing where the change might come from, in mathematical terms, means that we can’t properly assign the probability of an event happening. The problem is aggravated in different scenarios like if one tries to plan for the future, develop a policy or talk about investment decisions in financial markets. Hansen has a knack for capturing the vagueness of uncertainty with the rigor of mathematics. This way of thinking, with the purpose and intensity that the economics department of the University of Chicago is famous for, contributes to his successful way of modeling uncertainty.

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"When you mention words like ambiguity, uncertainty, they sound like words that are very imprecisely defined,” says his former graduate student Jaroslav Borovicka. “How Lars thinks about it means you need to define terms precisely. You face the problem of turning the loose notions of imprecision and ambiguity into mathematics, so that we can write models that can actually tell us something about the real world.”

Modeling in a way the public can relate to

On an unusually warm October day in Chicago, listening to Hansen reflect on his work makes us want to understand how he sees the possibility for stronger connections between models and policy. "Economists are good at coming up with different models of the future," he says. "We suspect they’re all not quite correct, but we don’t know exactly how they’re wrong. That’s the type of uncertainty that we really have to be thinking about."

"We have to take this term – uncertainty – that means so many different things and to try to look at the consequences or implications of formalizing it in different ways. Why does that matter for the economy? How does it matter for the design of economic policy? Unless I make something a little more formal, then I’m not going to be able to analyze it. I take it as a challenge."

Using econometrics to predict policy effects

Taking up the challenge to model uncertainty in the most realistic way possible puts Hansen at the forefront of research in this area. It’s his unique way of understanding how to model doubt within an uncertain model that gives his work appeal beyond the academic world.

His former graduate student and co-author Evan Anderson sheds light on the complexity of having uncertainty both outside and inside of an economic model. "Lars really wants economics to be useful,” says Anderson. “He knows that economic models don’t always explain the data the way we hope. He believes that individuals should take into account economic models when making decisions, but also realize that they are not perfect. Not only does Lars think that people should do that in the economy, he wants to build that into his models, so that his models of the economy have people inside the economy who doubt these models."

A road to less uncertainty through more education

How do we proceed with this awareness that doubt exists in both the future and the models? Hansen’s view is a testament to being an educator and coming from a family of educators, people who value acquiring knowledge above all. "Policy makers will naturally gravitate towards advisors who speak to them with great confidence,” he says. “But that great confidence isn’t warranted, it doesn’t always result in the most prudent policy making. I can sit and blame policy makers. But a lot of it has to do with also educating public thinking about uncertainty, about how to confront it or approach it in sensible ways."

Despite an intense schedule, the Nobel Laureate takes every opportunity to speak publicly. Most admirably, he goes to middle schools and talks to fourth and fifth graders about uncertainty. He explains complex ideas in a playful way so that the kids can learn in a fun and non-intimidating way about the nature of probability.

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Broad skills to face the challenges of a changing world

Education about doubt and preparing for an unknown future is also a way to cope with uncertainty. It’s the advice that Hansen gives to the young people as we wrap our conversation up.

"When you’re going to school, you acquire a broad range of skills. You become interested in mathematics, you become interested in sciences, you become interested in literature,” he says. “It gives you the flexibility to do a variety of things in the future. Even in the first part of college, I didn’t really know what I wanted to do. But the mere fact that I had acquired multiple skills of different types gave me the flexibility to pursue different things.”

The nature of jobs changes over time, but the broader skill set you have, the more it puts you in a position to be able to respond to such an environment and to thrive in it.

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