Lars Peter Hansen is a leading expert in economic dynamics who works at the forefront of economic thinking and modeling. He draws approaches from macroeconomics, finance, and statistics.
Hansen’s current work investigates three interconnecting areas: (1) macroeconomic uncertainty and financial markets; (2) struggling with a complex future; and (3) understanding investor beliefs through asset market data.
In this 4-minute documentary, “Incertitudes”, Lars explains why he seeks to better understand the role uncertainty plays in financial markets and the economy. (Produced by Histoire courtes.)
1. Tackling Uncertainty When Confronting Climate Change
Hansen and his collaborators develop and apply methods for confirming uncertainty and its impacts, broadly speaking, for the design and conduct of public policy. This research brings tools from decision theory and asset pricing to study uncertainty evaluation including the particular ramifications for the social cost of carbon.
Specifically, Hansen places emphasis on quantitative storytelling as a credible way to conduct policy analysis in dynamic settings. It combines so-called “stylized modeling” with empirical evidence. Hansen and his co-authors purposefully consider multiple stories, with carefully worked-out narratives that are formally captured as models, which have different ramifications for the environment and the economy. For dynamic problems such as the one of climate uncertainty, multiple “stories” are virtually impossible to dismiss on either theoretical or empirical grounds.
In their quantitative application, Hansen and his collaborators show that the social cost of carbon could become very large without additional forms of mitigation, technological change, adaptation and/or policy intervention. They abstract from regional and developmental heterogeneity, which should be part of a more full accounting. Of course, these limitations should be explored and they will alter the implied social cost of carbon. They are actively engaged in revealing extensions that will allow us to confront some of these shortcomings along with more ambitious climate inputs. In summary, this paper is not meant as the answer, but as their initial step in incorporating broad notions of uncertainty in a formal policy analysis while avoiding overstated claims of our current knowledge base.
- “Wrestling with Uncertainty in Climate Economic Models,” (with William ‘Buz’ Brock), SSRN working paper, October 2018.
- “Pricing Uncertainty Induced by Climate Change” (with William ‘Buz’ Brock and Michael Barnett), published in the Review of Financial Studies, February 2020.
2. Struggling with a Complex Future
Hansen and his collaborators explore important questions about the consequences for financial markets when investors are unsure about the future.
Formal and informal evidence from financial markets suggests that the markets vary over time in their concerns about uncertainty. What drives these fluctuations and how are they related to speculations about future macroeconomic performance? How should public policy be designed given our incomplete understanding how policy impacts the economy in subtle and not so subtle ways.
To investigate these issues formally requires a modeling framework where investors within the model sometimes struggle with how to make projections about future economic performance and even about which model is the best one to use
Hansen and his coauthors study how different forms of uncertainty, including risk, ambiguity and their resulting skepticism, impact financial market performance. They seek to advance understanding about the implications of uncertainty, especially for behavior of markets and the design of economic policy.
- “Macroeconomic Uncertainty Prices when Beliefs are Tenuous,” (with Thomas J. Sargent) published in the Journal of Econometrics, November 2020. [Discussion for the Non-Expert]
- “Structured Uncertainty and Model Misspecification,” (with Thomas J. Sargent), SSRN working paper, November 2020.
- “Twisted Probabilities, Uncertainty and Prices,” (with Thomas J. Sargent, Balint Szoke and Lloyd S. Han), published in the Journal of Econometrics Volume in Honor of George Tiao, February 2020.
- “Aversion to Ambiguity and Model Misspecification in Dynamic Stochastic Environments,” (with Jianjun Miao). PNAS, July 2018.
- “Ambiguity Aversion and Modeling Misspecification: An Economic Perspective,” (with Massimo Marinacci), Statistical Science 31 (January 2017): 511-515.
- “Four Types of Ignorance,” (with Thomas J. Sargent). Journal of Monetary Economics, 69 (January 2015): 97-113.
- “Uncertainty Inside and Outside Economic Models,” (Nobel Prize lecture), Journal of Political Economy, 122 (July 2014) 945-987.
- “Uncertainty within Economic Models,” (with Thomas J. Sargent). (World Scientific Publishing Co., 2014).
3. The Pricing Impact of Macroeconomic Uncertainty
Applied macroeconomic research quantifies how random impulses or “shocks” to the dynamic economic system transmit throughout the economy and affect outcomes over time.
Hansen’s recent collaborative research aims to assign prices to these shocks by building on and extending insights from asset pricing theory.
In financial markets, we know that investors are compensated for their exposure to added macroeconomic uncertainty, but we don’t yet know how or by how much. Hansen’s research seeks to answer the question, “What are the implied investor compensations for exposure to macroeconomic shocks over alternative payoff or investment horizons?”
Thus, his work is designed to provide a pricing counterpart to the impulse response functions used by macroeconomists. The drive to identify the long-term impacts of uncertainty motivates this work, and as a result, features revealing characterizations of the importance of the contributions to pricing that persist over time.
- “Term Structure of Uncertainty in the Macroeconomy,” (with Jaroslav Borovicka), Handbook of Macroeconomics: Volume 2B (2016) Chapter 20, Elsevier B.V., 1641–1696. [Discussion for the Non-Expert]
- “Examining Macroeconomic Models Through the Lens of Asset Pricing,” (with Jaroslav Borovicka), Journal of Econometrics 183 (November 2014): 67-90.
- “Shock Elasticities and Impulse Responses,” (with Jaroslav Borovika and Jose A. Scheinkman), Mathematics and Financial Economics 8 (September 2014): 333-354.
- “Dynamic Valuation Decomposition Within Stochastic Economies,” Econometrica 80 (May 2012): 911-967.
- “Risk Price Dynamics,” (with Jaroslav Borovicka, Mark Hendricks, Jose A. Scheinkman), Journal of Financial Econometrics 9 (January 2011): 3-65.
- “Long Term Risk: an Operator Approach,” (with Jose A. Scheinkman), Econometrica 77(1): 177-234, January 2009.
4. Investor beliefs as revealed by asset market data
Asset markets are forward-looking. They encode information about investor beliefs about the future and about investors’ concerns for risk. How can we use financial market data to extract information about these two components in a reliable way? Financial market prices can change because investors change their subjective beliefs about the future and because the risk prices that they are exposed to change. This research, which Hansen pursues with his collaborators, investigates this question by formally exploring the interplay among , investors’ beliefs, rational expectations, and the long-term consequences of exposure to risk.
- “Robust Identification of Investor Beliefs” (with Xiaohong Chen and Peter G. Hansen), November 2020.
- “Misspecified Recovery,” (with Jaroslav Borovička and José A. Scheinkman), Journal of Finance (December 2016.) [Remarks on Identification, Recovery and Martingales]
- “Uncertainty Inside and Outside Economic Models,” (Nobel Prize lecture), Journal of Political Economy 122 (July 2014) 945-987.
- “Stochastic Compounding and Uncertain Valuation,” (with Jose A Scheinkman), book chapter in “After the Flood: How the Great Recession Changed Economic Thought” (2014) 21-50.
- “Recursive Utility in a Markov Environment with Stochastic Growth,” (with Jose A. Scheinkman), Proceedings of the National Academy of Sciences 109 (June 2012): 11967-11972.