3 U.S. economists win Nobel Prize
The question seems simple, but shedding light on the answer was worth a Nobel Prize for three American economists: How do we know how much an item is worth?
Eugene F. Fama and Lars Peter Hansen of the University of Chicago and Robert J. Shiller of Yale University spent decades working on that problem, separately pioneering two competing views on finance that have strongly influenced the way people save and invest as well as major issues in public policy.
Fama, 74, spent a five-decade career in Chicago demonstrating how well free markets can determine the value of stocks, bonds and other assets. His work led to the now widely held insight that investors should put their money into broad baskets of stocks and not try to pick individual winners because no one person is likely to know more in the long run than the overall market.
That insight provided the underpinning for stock index funds that have since become investment vehicles for billions of dollars.
Shiller, 67, co-founder of the commonly used Case-Shiller housing price index, provided a vital counterpoint: He showed how markets can still badly malfunction because of behavior such as excessive optimism.
His insight helped him correctly anticipate the bubble in technology stocks more than a decade ago and the housing market boom before its collapse.
“In Fama’s telling, a stock price reflects the wisdom of crowds,” University of Michigan economist Justin Wolfers wrote in a column describing the work of the two men.
“In Shiller’s telling, markets can be subject to extraordinary popular delusions and the madness of crowds.”
It was Shiller who persuaded Alan Greenspan, when he was chairman of the Federal Reserve, to warn of “irrational exuberance” in the stock market before the dot-com bust, Wolfers noted.
Hansen, 60, developed key statistical tools to use real-life data to test hypotheses about asset pricing. Though he is less known to the public than Shiller or Fama, Hansen’s methods for analyzing data and studying relationships have become standard tools for social scientists.
The Nobel committee, in announcing the $1.2-million prize that will be split among the three economists, largely glossed over the sharp differences in Fama’s and Shiller’s work. Instead, the Royal Swedish Academy of Sciences focused on their common effort to examine markets, honoring the trio for having “laid the foundation for the current understanding of asset prices.”
But the difference between the two has major implications for public policy. If markets are fundamentally rational and efficient, then most government efforts to intervene in the economy will be futile at best. But if markets are inherently flawed because of basic irrational elements of human nature, then well-designed government policies can provide better outcomes.
In 2010, two years after the onset of the financial crisis, Fama maintained that pricing remained rational. On Monday, John H. Cochrane, a University of Chicago economist who is also Fama’s son-in-law and shares his views, challenged the notion that we could even know what a bubble was.
“If your home prices are surging, how do you know it’s irrational exuberance? Maybe the price should be double,” he said. And if we don’t know when a bubble exists, he asked, how can policymakers such as members of the Federal Reserve Board possibly take preemptive steps to pop it?
“It’s a recipe for a disaster for the government,” he said. “They don’t know what the price of tomatoes are going to be; forget about housing.”
Shiller said during a news conference Monday that the Case-Shiller housing index that he helped develop — a systematic measure of home prices in U.S. cities — showed prices had risen 18% in inflation-adjusted terms from the bottom of the market in March 2012.
“Whether it’s a new boom or a new bubble,” he said, “I think it’s still an unanswered question.”
This year’s awards did not mark the first time that the prize, formally known as the Nobel Memorial Prize in Economic Sciences, has been given to scholars with seemingly opposing views. In 1974, Friedrich August Hayek, the Austrian libertarian economist, shared the Nobel with Karl Gunnar Myrdal, the liberal Swedish scholar known for his studies of inequality.
The latest award marked yet another economics Nobel for the University of Chicago, which said Monday that it now had 28 laureates associated with the university, including six economics winners currently on the faculty.
Fama’s ideas are known as the “efficient market” hypothesis — the view that markets function very well, involve rational agents and incorporate all available information at any given moment. If markets are so efficient that they reflect everything people know, the thinking goes, then we can’t predict tomorrow’s prices because there shouldn’t be any information that has not already been factored into the price.
Indeed, as most individual stock pickers can attest, beating the market in the short run is extremely difficult. Fama’s work, done primarily in the 1960s and ‘70s, gave rise to index funds that collect all stocks in passively managed portfolios. Many who believe in efficient markets have eschewed fund managers, figuring that even the most ballyhooed managers have no better insight into future performance than the proverbial monkey throwing darts.
That theory has taken a hit in recent years after the housing crash and the Great Recession as markets have been too volatile to be considered efficient. Few have explored the depths of market inefficiencies as Shiller has.
Widely considered a favorite to win the Nobel, Shiller is probably best known for his popular books that warned about bubbles in the stock and real estate markets.
He is coauthor of “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism,” which he wrote with George Akerlof, another Nobel laureate and the husband of Janet L. Yellen, President Obama’s nominee to head the Federal Reserve.
As Shiller’s book suggests, his research has mined the field of behavioral finance, exploring how human psychology can move asset prices and helping explain why prices sometimes deviate from fundamental values.
“Shiller suggested early on that important risks facing investors are sometimes hard to measure and thus are non-insurable by existing market instruments,” the Nobel committee said. The panel noted Shiller’s contribution to the Case-Shiller index, which is widely used by policymakers and industries to gauge trends in the real estate market.
Economists point out that Fama too has spent considerable effort investigating exceptions to the efficient markets hypothesis. He has found, for example, that small firms can yield unusual returns.
The two economists’ views are not as different as some people portray them, said Tyler Cowen, an economics professor at George Mason University and author of “The Great Stagnation.”
“Both are looking to better understand the sources of what are called ‘excess returns,’” or why a portfolio can sometimes rise above the performance of the market in general, he said.
