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 the absence of
measurement errors. The difficult question then is to determine
what should be considered sufficiently good, or better
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. Methods used in mathematical
statistics could then be applied to draw stringent conclusions
about underlying relations from the 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 the 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 sufficiently 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 Probability 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 Simultaneous 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 Study in the Theory of Investment* (1960).

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