Add together the diametrically opposed beliefs of two of the three economics Nobel Prize winners, says guest poster David Howden, and you end up with a big fat zero.
The paradox of the awarding of the 1974 Nobel Memorial Prize in Economic Science1 is really just par for the course. Friedrich Hayek and Gunnar Myrdal shared the prize that year – both for their work on monetary fluctuations and the business cycle. While there were some affinities between the two early in their careers: both used a Wicksellian foundation, stressed the importance of Knightian uncertainty and the role of ex ante expectations versus ex post results in investment decisions. But by the time the elder economists won their Nobels they were almost polar opposites. Hayek had moved to his work on to the social order of a free society while Myrdal had taken on a decidedly more socialistic bent.
This year’s Nobel Prize is shared between three eminent economists, Eugene Fama, Lars Peter Hansen and Robert Shiller. For the purposes of this article commemorating their achievement, I wish to compare Fama and Shiller’s accomplishments, contributions and what the Prize really represents. As we shall see, though both academics won the award for their work on asset prices, their results and conclusions couldn’t be more at odds with each other.
Fama is most famous for this work on the Efficient-Market Hypothesis (EMH). Loosely stated, markets are efficient when all relevant information pertaining to a business is factored into and reflected in its stock’s price. Since future information concerning the stock is not yet known, and cannot be known, there is no way that any investor can “beat” the market. Fama built on this conclusion, and went one step further. Not only can one not beat the market, but any market return will be random – the unknowable nature of the future implies that any stock’s price must follow an unpredictable “random walk”
Such a conception of knowledge and efficiency seriously misconstrues the nature of both concepts. For the Efficient-Market Hypothesis to hold true, not only must all knowledge be interpreted in the same way by all investors, but the impact of that knowledge must also be identical among everyone! The first statement removes any subjective element from knowledge formation, and in its place the theory is built upon an objective element. The latter statement implies no differences in investors – everyone must have the same goals, interpret new knowledge in an identical way, and even have an identical time preference scale. (Interested readers can see my previous work on the Efficient-Market Hypothesis (pdf) here and here.)
If EMH is a boring fairytale describing how people could act under the most unrealistic of conditions and how markets are efficient as a result, Shiller’s work revolves around searching for ways that markets are inefficient.
One of Shiller’s best known works is his 1981 article titled “Do Stock Prices Move Too Much To Be Justified By Subsequent Changes In Dividends?” in which he challenged the dominant position of the efficient-market hypothesis. His subsequent work looked at what role behavioural aspects create economic bubbles.
In many ways, Shiller is one of the most forceful characters in behavioural finance. Some key themes of this sub-discipline is the belief that economic agents make decisions based on simple heuristics and rules of thumbs, in contrast to logic. Behaviourists believe that how a person frames a problem (i.e., “stereotypes” it) will determine how he responds to an event in addition to the cold, hard relevant facts. Finally, a mainstay of traditional behavioural economics is the belief that markets are, or at least can be, inefficient – whether this be by asset mispricing's (mistakes) or non-rational decision making.
It is not a stretch to state that behavioural economics has nothing in common with EMH.
Outside of the ivory tower, Shiller is likely best known for his 2000 book, Irrational Exuberance. Starting from the belief that investors are subject to fits of, well, irrational exuberance, Shiller wrote how the apparent stock market bubble at the time was caused by investors unrealistically setting their expectations of future returns not on any fundamental event, but rather on their own out-of-control beliefs concerning future growth.
Interestingly, Eugene Fama was a stark critic of both the book and Shiller’s approach, commenting that “Bob … has been consistently pessimistic about prices.” Indeed, in the same interview Fama boasted of having cancelled his subscription to The Economist because of the magazine’s overuse of the phrase “bubble.” This was on April 26, 2010, less than a year and half after the onset of a crisis that almost every commentator, economist and layman would say was precipitated by a bubble in sovereign debt, personal borrowing, and housing prices.
Indeed, Philipp Bagus and I had similarly harsh words about Shiller in our review (pdf) of his 2008 book The Subprime Solution. We not only chastised Shiller’s total neglect of reduced underwriting standards and extreme credit creation as causes of the crisis, but also of his recommendation that the U.S. government implement a new New Deal. In nominal spending terms the U.S. government has done just this over the past five years, and we can see what good it has done the economy. (As well as the debt overhang it has created for future generations of Americans.)
Eugene Fama and Robert Shiller have almost nothing in common, short of both being well known economists who work in the broad field of asset pricing. Their approaches are diametrically opposed to each other. Their predictions about asset prices and the ability of economic agents to make informed and “correct” decisions could not differ more, yet they are the co-recipients of this year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
Unlike in real life, the Nobel committee and the economists it shadows praise on are not constrained by an unfortunate fact of life: losses. The investment world is not about armchair theorising. Investors price assets based on models predicated on both the Efficient-Market Hypothesis and behavioural aspects. The pension funds of widows and orphans are run by bankers and economists trained in the spirit of these Nobel laureates’ works.
This year’s Prize is a heist. Both Fama and Shiller may be praised for their work, which is judged as insightful independent of its usefulness or correctness, but others of us know better. Bad theories that cause losses matter. Worse yet is the misplaced credibility that this Prize bestows to its recipients.
Five years ago, President Barack Obama was awarded the Nobel Peace Prize for his “extraordinary efforts” in establishing international cooperation. We have seen how that turned out, and one beneficial side effect is that this unearned award brought the whole Nobel committee and process into disrepute. Let’s hope that this year’s recipients can have the same effect on the prestige of the economics Nobel.
David Howden is Chair of the Department of Business and Economics, and associate professor of economics at St. Louis University, at its Madrid Campus.
This post first appeared at The Circle Bastiat.
1. Nobel Prize in Economics? As Jorg Guido Hulsmann explains,
The great Swedish entrepreneur, Alfred Nobel did not sponsor a prize in economics, and the committees sponsored out of his estate did not grant any such prize until the present day. But there is a “Prize in Economic Sciences in Memory of Alfred Nobel” which is sponsored by the central bank of Sweden. Since 1969, that prize has been granted every year in early October, [at the same time as the annual Nobel Prize winners are announced in the fields of literature, medicine-physiology, physics, chemistry, and peace-making].
The timing and the labelling of the economics prize, as well as the fact that its laureates are selected by the Royal Swedish Academy of Sciences, which also picks the other laureates (except for the peace prize), have misled people all over the world into thinking it is the real thing. Like counterfeit banknotes, the economics prize has been circulating among the unsuspecting public.
Alfred Nobel did not intend to sponsor a prize in economics. Apparently, neither did the Swedish central bank. Its prize has usually been awarded to scholars specializing in applied mathematics, or applied psychology, or in the art of playing with statistical data that goes under the name of econometrics. Very rarely is it awarded to scholars who actually spend most of their time thinking about real-world economic problems, and almost never to anybody who has anything new and important and true to say about the real economy. It is true that many laureates were very well versed in economics, but even they did not, as a rule, obtain the prize for any contribution to that discipline.
The problem with the “dismal science” of economics is well known. It mercilessly exposes and dispels the myths that have been invented to justify central planning and government interventionism. This flies in the face of the very institutions that finance and award the Prize in memory of Alfred Nobel. The Swedish central bank is institutionally committed to central planning in money. It can hardly be expected to print and spend millions of kronas on research that is useless — and potentially nefarious — from its very own point of view. Moreover, Sweden has been ruled by socialists for most of the post-war period. The venerable Royal Swedish Academy of Sciences was not immune from this tendency.
Unsurprisingly, the economics prize has always been heavily biased against economists who oppose the fiat-money foundation of the welfare state and of the warfare state. The facts speak for themselves. With the notable exception of F.A. Hayek (laureate in 1974), none of the prize winners is on record as an outspoken critic of central banking and monetary interventionism…