Today, Eugene Fama, Robert Shiller and Lars Peter Hansen were awarded the Nobel Prize in Economics* for their research into how financial markets price the things they sell.
A typical reaction, courtesy Belgian economist Paul de Grauwe:
Nobel Prize for Fama who led millions to believe financial markets are efficient and for Shiller who showed opposite. What a contradiction.—
Paul De Grauwe (@pdegrauwe) October 14, 2013
He’s not wrong! After all, Shiller warned people about a housing bubble in 2007, while Fama still denies it even existed. (Pity poor Hansen, whose econometric innovations help better measure asset prices and advanced Shiller’s theories but are much harder to articulate.)
But it also gets at why the Nobel committee selected these three—because figuring out the right price for something isn’t easy. Or, as the Nobel committee put it (pdf), “we do not yet have complete and generally accepted explanations for how financial markets function.”
Fama’s famed “efficient market hypothesis” suggested that markets incorporate all available information into pricing, which means their prices aren’t predictable enough to make money on—if you think you know something nobody else knows about a stock, you’re probably wrong (or maybe you work at SAC Capital). Opportunities for arbitrage should disappear quickly, picking stocks is a mug’s game, and investing across the market rather than in specific assets is the best way to profit in the long term. If you like exchange-traded index funds or have ever thought about how to find “alpha,” thank Fama.
Shiller had other ideas. He saw markets acting positively stupidly, infected by the very human impulses of the people buying and selling. His ideas were the beginning of “behavioral finance.” Fads drove market participants to binge on tech stocks or mortgage bonds even after information emerged about the startups’ lack of profitability or when the default rates on home loans were too high. If you see bubbles everywhere you look, thank Shiller.
One good way to look at the debate is the positively Hegelian approach of fellow economics laureate Paul Krugman: “Fama’s work on efficient markets was essential in setting up the benchmark against which alternatives had to be tested; Shiller did more than anyone else to codify the ways the efficient market hypothesis fails in practice.”
Indeed, what’s notable is that for all his time spent identifying market failings, Shiller’s solution was to build a better market. He co-created the Case-Shiller Home Price index, the first data set that allowed anyone to see trends in US real-estate sales. The index introduces more information to the markets, and more importantly, could allow homeowners—and for many US families, homes are the largest asset they own—to hedge against future housing bubbles. That development would make markets much more efficient.
*Technically, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.