Thoughts on the “Nobel” Prize in Economics
This is that special time of year when MarginalRevolution destroys Free Advice in not only objective but also subjective value. Alex and Tyler have so many posts on the new economics laureates that I would just direct you to MR on October 14, 2013.
The most obvious reaction is to ask: Did the committee just give the award to two guys who said the opposite thing? Namely, I am pretty sure all of the following are correct statements:
(1) Eugene Fama is the father of, and believe in, the Efficient Markets Hypothesis (EMH).
(2) Robert Shiller did not believe in the Efficient Market Hypothesis.
(3) Fama and Shiller shared the Nobel for their work on asset prices and financial markets.
Ishn’t zat veird? (Scott Sumner kinda sorta agrees.)
I never got into the technical papers on the EMH, so I do not feel competent to weigh in on them. I know there are varying strong and weak forms of the EMH, that it’s not merely a tautology, that they performed falsifiable tests, etc.
However, what I am confident in saying, is that when commenting on the economy for a lay audience, the believers in the EMH use it in a non-falsifiable way. That would be fine, except that they don’t realize they’re doing it.
My two articles (here and here) lay out exactly what I mean by such an accusation. If you’ve been reading me a while, you know that I am the epitome of humility, but those two articles I just linked are really awesome, incidentally.
A nobel prize for people who believe opposite things? That remembers me that 1974’s moment
I was waiting for this post all day, lol.
Ish zat veird? I don’t know, is Fama from Holland or something?
Although I don’t think much of those partly politically influenced beauty contests rich in vitamin B (= favouritism), be it Grammies, Oscars or Nobels etc., my (only) suggestion for a fairly well deserved and I think completely uncontroversial Nobel in economics, was if they would honor Gossen, Jevons, Menger and Walras for their work on marginal utility with the Nobel in economics.
I have just read some layman explanations of what Hansen did. Am I right in saying that Hansen’s work is a specific method of how to extrapolate data?
With ‘layman explanations’ I mean for laymen from professionals, not from laymen…
😉
I think of a lot of the EMH claims like I think about rational expectations – good first approximation that moved modeling and the filed forward that were right chipped away at on the margins as more research was done.
The only stark contrast is people who see these claims as being more than that (and that may include Fama himself – like you I don’t know the literature in detail).
This is the distinction between understanding these things as statements of Truth vs. understanding them as modeling conventions that help make important ideas more concrete and tractable.
The Atlantic made an interesting point that Fama and Shiller really have short run disagreements and are very much on the same page on the long run.
Mr Murphy,
I do not think that your statement #2 is entirely true. I do not think that Shiller believes that markets are totally inefficient.
Lio, NOT_100%-EFFICIENT is not equal to ZERO%-EFFICIENT.
Fama’s contributions to Finance are great. An overview here: http://johnhcochrane.blogspot.fr/2013/10/gene-famas-nobel.html#more
““Efficient markets” does not mean that the market will always be correct. What efficiency means is that the markets aggregate the information that people have and reflect it quickly into asset prices.”
Gene Fama
I can subscribe to that. Though I might add that it is not only about information (real data/facts) but also believe/sentiment that is priced in just as efficiently. I think the latter being mainly responsible for a lot of short term noise in the markets. The hard part is in trying to distinguish price movements caused by the former from the latter.
“Quickly” is the operative word. Fama is compelled to accept that price discovery and formation takes place over time.
But we know that not everyone is equally fast in collecting information and utilizing such information to price securities, and we also know that not everyone collects the same quality of information either.
The EMH is one among many a priori theories that result from equilibrium thinking.
“But we know that not everyone is equally fast in collecting information and utilizing such information to price securities, and we also know that not everyone collects the same quality of information either.”
1/ True. Fama never said otherwise. Fama just gave “Efficiency” a precise and testable meaning. For nearly 40 years, the empirical results concluded to a high degree of “efficiency” in the major liquid markets. In other words, markets are much closer to efficient than anybody thinks. But it does not mean that inefficiencies cannot exist.
2/ EMH does not mean that the market is always right, which is a misunderstanding often found on the Web.
Ironically, Mark Thornton, Peter Schiff and Austrian Business Cycle Theory went on to make many incorrect predictions about inflation after making a correct prediction about housing prices. Just like Fama would have guessed.
More here: http://badoutcomes.blogspot.com/2013/10/murphy-attacks-emh-with-evidence-of.html
Also, there is a since in which the EMH is untestable. In Finance, it is called the Joint Hypothesis problem, and it is part of the contribution for which Fama won the prize. Basically, the problem arises when you try to get serious about what it means to “beat the market.” What that can’t mean is earning a high return for taking a lot of risk. For a long time, small stocks have earned higher returns than large stocks, but if that return is just a premium, because small stocks are riskier, then investing in small stocks can’t be considered beating the market.
Thus, testing whether markets are efficient requires some model of risk. It’s not enough to say some strategy earns high returns. Yet, we don’t know what the right model of risk is, so every test of the EMH is also a test of an asset pricing model. Either a high return represents that market’s are inefficient or it represents some compensation for risk that we don’t really understand–the joint hypothesis problem.
More and citations in these posts:
http://badoutcomes.blogspot.com/2012/11/the-emh-isnt-testable-and-thats-ok-part.html
http://badoutcomes.blogspot.com/2012/11/the-emh-isnt-testable-and-thats-ok-part_30.html
Even though I’d self-identify as an Austrian, I find that using a mental framework involving the EMH helps me understand things a lot better. In addition, it has made me a lot of money in the stock market because it convinced me to buy low-cost index funds instead of wasting my money in the hopes of beating the market.
Austrians should incorporate the ideas behind the EMH in at least some form. For instance, the biggest declines in the stock market in 1929 happened when the Smoot-Hawley tariff act made progress. Regardless of ideology, stock prices do an amazing job of communicating information just like the price of any other good. It really bugs me when people like Peter Schiff constantly say stocks are a bubble. New information constantly comes out and changes the expectations of companies making money in the future and stock prices reflect that. If you ignore this fact, you can come across looking like an idiot. I think Austrian economists constantly calling bubbles tremendously discredits them and their economic thinking and I wish they’d stop it.
Let’s suppose you had some supply of information, perhaps you spend a lot of time interviewing people in the street, or perhaps you study new regulations (which are continuously pumping out), or some similar activity (presume it’s legal information, not that the principle changes).
OK, so buying stocks based on this additional information does two things: if your research is good, you can “beat the market” and make a profit so long as you remain one step ahead of the other market participants, but the second effect is that your trading will modify the price and thus reveal your information to the market, requiring you to go back and do more research.
Thus, it is no different to working a job and getting paid to do research. If Schiff is a bit better at analysing the key factors than the typical market participant then he gets paid to reveal his knowledge, if he is wirse then he must pay for someone else.
Buying index funds makes sense if you know you have no special information or you would rather spend your time working some other job, maybe something you enjoy, or happen to be better at.
Getting back to Schiff, you only make money by correctly spotting a bubble if you can bet on the crash, so you have to both see the bubble and time the crash. Anyone who can do this should be paid for their skill, IMHO it seems quite fair.
The cost of useful information in the stock market is very high and rapidly approaches infinity. The only real way to reliably beat the indexes today is to act on new information first with supercomputers.
Index funds outperform over 90% of managed funds once you account for costs. Many, many, many very smart people make it their entire job to try and beat the market and there is no evidence that they have the ability to do so. That is powerful evidence for some form of the Efficient Markets Hypothesis.
Even assuming that Schiff was a genius for calling the housing bubble rather than a permabull who got it right once, being early is the same thing as being wrong from the standpoint of your bottom line.
The hypocrisy I’m accusing some Austrians of is saying that other non-manipulated market prices are communicating information and are correct by definition whereas stock or real estate prices are constantly in some sort of bubble. Volatile assets will make large moves. That is not prima facie evidence of a bubble.
Not so weird.
http://noahpinionblog.blogspot.com/2013/10/if-fama-were-newton-would-shiller-be.html