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Wednesday, October 16, 2013

Nobel to the Warring Economists!

The Sveriges Riksbank Prize in Economic Sciences, in Memory of Alfred Nobel, for the year 2013 has been awarded to Eugene F. Fama of University of Chicago, Lars Peter Hansen of University of Chicago and Robert J. Shiller of Yale University—all from the USA "for their empirical analysis of asset prices”.

As Solow, the former winner of Nobel in economics observed, this year's winners are a "very interesting collection" for the simple fact that although all the three of them have worked on asset pricing mechanisms, they have theorized differently.   

It is Eugene Fama, the pioneer of efficient markets, who demonstrated in the 1960s that stock prices are extremely difficult to predict in the short run, for their price movement looks like a random walk — future price movements can’t be, predicted from past price movements alone. He also established that new information, such as an increase in a stock's dividend, was quickly absorbed into the asset price. His efficient market theory states that stocks are always correctly priced since everything that is publicly known about the stock is reflected in its market price. Therefore, he asserts that one cannot simply 'beat the market'—more so when large number of people trade in the financial markets. So, the only way to beat the market is through private information, asserted Fama. However, there are economists who—right from the beginning harboring reservations about the plausibility of efficient market theory—have been arguing that sharp moments in stock prices such as the one that the market had witnessed during 1987, cannot be explained by it. On the other hand, they argued that market, from a macroeconomic perspective do reflect the waves pessimism or optimism of the investing community.

Nevertheless, Fama's  theory of efficient market had revolutionized the practice of investing all over the globe, leading to the emergence of index funds. His theory—markets are rational and efficient—indeed led to the deregulation of financial markets, beginning in the 1980s. It is no exaggeration to say that indeed it is this belief about the market that left the regulators in complacence about the rising house prices in 2000 in the US. 

Driven by this philosophy of the price discovery mechanisms in financial markets, Fama argued in 2010 that there was no housing-price bubble in the US prior to the financial crisis of 2008. Indeed he went to the extent of arguing that “bubble” is a meaningless term.

Two decades later, Robert J. Shiller of Yale University came up with a suggestion that there is more predictability in the long run in stock and bond markets. He found that stock prices fluctuate much more than corporate dividends, and that the ratio of prices to dividends tends to fall when it is high, and to increase when it is low. This pattern holds good not only for stocks, but also for bonds and other assets. Shiller became famous for saying that markets frequently do not act as if they are efficient, or even rational. He, pointing at the excessive volatility prevailing in stock prices for reasons other than asset-specific information, demonstrated that markets are not always rational. Harping on this ‘mispricing’, Shiller popularized the concept of “irrational exuberance” as the defining element of the erratic market behavior.

Shiller was so enthusiastic about his belief—mass psychology may well be the dominant cause of movements in the price of the aggregate stock market— that he wrote in his book, Market Volatility, published by MIT Press in 1989:  the assertion that the stock prices were rational was one of the most remarkable errors in the history of economic thought. Later Shiller became famous for his warning the market against bubbles in technology stocks in 2000 and housing prices in 2006. Shiller is also known for developing, along with Karl Case, a Wellesley College economist, the Case-Shiller index, a leading measure of US residential real estate prices.

Holding such contradicting views, Eugene Fama, who pioneered the notion of efficient markets and Robert Shiller, who was in the frontline of economists warning about irrational investor behavior, obviously, haven't always seen eye to eye over markets' ability to value assets correctly. But then they have been now selected to share the Nobel: Prof. Fama for showing that markets were efficient, and Prof. Shiller for showing that that the markets were not. And that’s what is interesting about this year’s selection.

Moving on, we have the third candidate, Lars Peter Hansen, University of Chicago, who has been selected to share the prize for developing statistical models to show how investors priced risk, in particular a new statistical method created in the early 1980s called
the Generalized Method of Moments that helped evaluate theories about price movements. Hansen’s work is indeed instrumental for testing the advanced versions of the propositions of Fama and Shiller. Hansen is currently the Research Director of the Becker Friedman Institute, where he, along with economist Andrew Lo, co-directs the Macro Financial Modeling Group—a network of macroeconomists working to develop improved models of the linkages between the financial and real sectors of the economy in the wake of the 2008 financial crisis.   

That said, we must now admit that by selecting economists harboring contradicting views about market behavior, the Nobel Committee, perhaps, wants to emphasize that there is no the answer to the question: How do markets work? And that is pretty interesting, for it says that economics is not an exact science and predicting human choices is dicey! For, we do not know how to connect the “lot of foolishness” that Robert Schiller sees all around which he “can’t believe it’s not important economically” to the science of stock price discovery!


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