The noblest Fama and Shillerby Michael Roberts
Eugene Fama, Lars Hansen and Robert Shiller have won the 2013 Nobel prize in economic science – in many ways for different theories about financial markets. The NYT put it: “Fama was honoured for his work in the 1960s showing that market prices are accurate reflections of available information. Shiller was honoured for circumscribing that theory in the 1980s by showing that prices deviate from rationality.”
It is ironic that three professors of economics are awarded Nobel prizes for their expertise in understanding financial markets when mainstream economics signally failed to see the financial crash coming in 2008 and have been unable to explain why it happened since or what to do about it. Robert Shiller might disagree as, after all, he warned that a housing bubble was building up in the US and heading for a bust, while Fama was arguing that prices are always rational indicators of supply and demand and so there was no bubble to be detected.
But in one way Fama was right: the movement in the individual prices of stocks and bonds is “extremely hard to predict over short horizons.” And prices do move quickly (and efficiently?) to absorb any ability of investors to take advantage of others and make profit (as long as the market is not rigged, of course!). His Efficient Markets Hypothesis (EMH) basically asserts, in the words of the economist Burton Malkiel, that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”
The usual economic joke about EMH is that an economist and his friend come across a hundred dollar bill lying on the ground. The friend goes to pick it up, but the EMH economist says don’t, it’s not necessary. If it were a real bill, someone would have already picked it up! As neoclassical economist John Cochrane put it: “The central prediction of the EMT is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats nor crafty hedge fund managers, nor ivory tower academics. This is the best tested proposition in all the social sciences”.
For this insight, all potential capitalist investors should be thankful to Fama and realise that investing in the stock market is no smarter than betting on a horse. But for society as a whole, the question is whether financial markets are useful and efficient at all. That is a different question and one on which Fama has nothing to say. His EMH implies that if markets are left to themselves and market agents have enough information, then an economy will perform efficiently and without disruption. Well, after the Great Recession, he was asked what went wrong. He replied casually, “We don’t know what causes recessions. I’m not a macroeconomist, so I don’t feel bad about that! We’ve never known. Debates go on to this day about what caused the Great Depression. Economics is not very good at explaining swings in economic activity”.
Shiller, on the other hand, reckons that financial markets in the aggregate can be predicted over long periods. Financial prices are driven by human behaviour that is often ‘irrational’ in the sense that decisions about buying and selling financial assets may not follow the ‘efficient’ prescriptions of economists. In 2000, Shiller published Irrational Exuberance, a book that detailed his view that stocks were overvalued at the time. So, at first sight, Shiller is diametrically oppsoed to Fama. But is he?
As one blogger put it (http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2013/10/shiller-vs-fama.htm), “Fama’s thinking is sceptical of the possibility of price bubbles, whilst Shiller’s shows that they can happen. But in another sense, their work is actually compatible, because they are talking about different things. Fama’s work is primarily about individual stocks. Shiller’s work, by contrast, has focused more upon the aggregate market.” Shiller argues that investors and economic agents are so irrational that speculation, ‘herding’ and uncertainty can lead to instability and economic crisis. He wrote a book with George Akerlof, called Animal Spirits, the Keynesian term for investment motivations. Another Nobel prize winner, Akerlof is married to Jane Yellen, now to succeed Ben Bernanke as head of the US Federal Reserve. Yes, it is all a very cosy club.
Shiller and Akerlof are supporters of what is fashionably called ‘behavioural economics’ i.e. the changes in a capitalist economy can be best explained by changes in the unpredictable behaviour of consumers and investors. That sets off a chain of connections for the demand for money, in investment decisions and in spending. This is the inherent flaw in a modern economy: uncertainty and psychology. It’s not the drive for profit versus social need, but the psychological perceptions of individuals. Thus US home price collapse came about because consumers’ ‘animal spirits’ gave way to a bias towards precaution and savings as debt mounted – just like that.
And Shiller recently published a book, Finance and the Good Society, in which he argues that, even after the crisis, rather than condemning finance, we need to reclaim it for the “common good” (see the interview in May 2012 (http://voxeu.org/vox-talks/finance-and-good-society). So we must be nicer to banks (see my post, http://thenextrecession.wordpress.com/2012/08/09/five-years-on/) . As one blogger put it, most people who think that markets can be inefficient are anti-market. Shiller’s solution to market problems, however, is more markets!
Robert Shiller is best known for warning about the internet stock market bubble and later the housing bubble. What is most impressive to me, however, is that most people who think that markets can be inefficient are anti-market. Shiller’s solution to market problems, however, is more markets! – See more at: http://marginalrevolution.com/marginalrevolution/2013/10/robert-shiller-nobelist.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+marginalrevolution%2Ffeed+%28Marginal+Revolution%29#sthash.eoa926gK.dpuf
In his book, Shiller tells us the “the problem is, and this is what’s bothering people these days, a strictly for-profit corporation just seems selfish. And it is selfish, because focusing directly on profit is just not humane.” Shiller pleads to bankers that “when you think of finance, you come to it thinking “Make money! Get rich!” You should instead think about financing activities, things that people do together that are important to them. Achieving goals that are shared by groups of people. Financing activities is what it’s all about.”
How true, but how is that to be achieved in the world of modern finance capital? Shiller says that we need a new kind of financial corporation that he calls a ‘benefit corporation’. Apparently it is “halfway between profit and non-profit”. The benefit corporation makes profits and distributes them to shareholders just like a for-profit corporation. The only difference is that the corporate charter specifies a purpose – a social, environmental or charitable purpose – in addition to the profit-making purpose. If such banks are set up “I think everyone will feel better”.
Shiller attacked the Marxist view specifically. “Karl Marx said the capitalists dominate because they own the capital. And the other people, the working class, have no access to capital.” Shiller rejects this view because “as modern society becomes more inclusive, everyone who becomes knowledgeable about finance can have access to capital. You don’t have to be born rich; we have a mechanism that allocates capital, that’s the financial system at its best use.” Really, can anybody set up a bank and make it work on an ethical basis so as to allocate capital in the interests of society?
Shiller says yes. You don’t have to be rich to “develop a business plan and present it to a venture capitalist… In the modern economies I think they really don’t care what social class you came from. You could be very working-class and, before you know it, you have millions of pounds to allocate, and that is the way that it’s increasingly working. That is the fundamental flaw in Marx’s thinking. He thought that these social classes were permanent and hopeless. We’re learning that it’s not. We should seek more progress, more democratisation of finance in the future.”
But Marx’s point was not that financiers would not take a good idea for profit from a working-class person. Of course, they would. The point was that the owners of capital control the allocation of society’s resources and do so on the basis of profit, not social need, which is only an accidental by-product in the best case, or completely destroyed in the worst case (as over the last six years). Fama’s solution to avoiding another financial collapse and another Great Recession is there isn’t a problem. Markets should efficiently allocate resources. A slump is really a way in which markets ‘return to the mean’ and remove any excesses. Sorry about the collateral damage – unemployment, bankruptcies, the slashing of services etc. You cannot tell whether market prices are out of line anyway.
Shiller says markets can get out of line and then cause busts. This is due to the irrational behaviour of human beings, not to the drive for profits by private capital. The answer is to change people’s behaviour; in particular, big multinational companies and banks need to to have ‘social purpose’ and not just want to increase profits. That is really like asking a lion if he would keep his claws in while stroking the lamb.
For these insights, we are truly honoured.