The three U.S. economists awarded the Nobel Memorial Medal in Economic Science last week have all done good work and deserve the honor. They were grouped together because they worked in the same general area of finance: how markets determine the value of assets like stocks, bonds or commodities.
But unlike most joint award winners in the hard sciences, they did not work as a team.
But Eugene Fama, at the University of Chicago, and Robert Shiller, at Yale, differ on at least one question: How important is rationality in human decision-making?
This question is fundamental to the future of economics.
Fama’s thinking starts — as most economic theorizing has for two centuries — with the assumption that rationality dominates human decision-making.
The rest of his ideas on asset prices in markets flow from that.
In contrast, Shiller argues that when humans make economic choices, irrational impulses — or “animal spirits” in John Maynard Keynes’ famous phrase — often eclipse the rational weighing of benefits against costs and their probabilities.
The rest of his thought proceeds from that. They cannot both be right.
So the Nobel committee punted, just like it did in 1974 when they awarded the prize to Swede Gunnar Myrdal and Austrian-American Friedrich Hayek “for their penetrating analysis of the interdependence of economic, social and institutional phenomena.” Myrdal’s analysis supported socialism.
Hayek’s argued that socialism was doomed to failure and oppression. The committee understood that one or the other eventually would be proven wrong by history. Unwilling to narrow their bet, they gave the award to both. That is what they did again this year.
Let foolish me rush in where angelic Swedish award granters dare to tread: Shiller will be treated better by history. Fama’s work will be respected for a long time. He is a very bright and original thinker whose conclusions have changed how ordinary people go about investing. His ideas influenced many other scholars of finance. This will last even after the consensus of economics abandons the assumption of dominate rationality that long has prevailed in economic thought.
His place in history will be similar to that of a bright physicist doing original work based on Newtonian assumptions in the 1890s, just before the revelations of Einstein’s relativity theory and of quantum mechanics. Some of his work will stand, but he will end with a reputation of having stood flatfooted on the platform as the train of intellectual history pulled out of the station.
Shiller and Fama agree that stock or bond prices cannot consistently be predicted in the short run. Markets, the aggregate actions of millions of people buying and selling, digest new information that can affect the profitability and hence the value of any such security almost instantaneously. Such information might be news of an oil strike, a budget agreement in Congress or a scandal involving a CEO.
At any point in time, the price of a security reflects all available information. No one can consistently guess better than the market. Yes, in any instance, some people make a better interpretation of new data than others and make money. However, they also will make bad interpretations and occasionally lose money.
Things even out. They will do about as well as the market as a whole. Hot mutual funds in one year will be dogs in another.
Fama thinks the efficient adjustment to new information minimizes fluctuations and that long-run prices are as unpredictable as short-term ones. Shiller disagrees, arguing that irrational impulses foster price swings up and down that are not justified by underlying conditions. This can be true particularly in the medium and long term.
They thus differ on the possibility of unjustified, unsustainable bubbles in prices of stocks or real estate. Fama claims to not even know what an asset bubble is, since his theory says they cannot happen. Shiller thinks they are possible, and even predicted that there was one in U.S. house prices a full six years before prices collapsed late in the last decade, triggering our recent severe recession.
Readers should note that Shiller says house prices are once again rising to unsustainable levels and that farmland prices reflect a severe bubble.
Forty years ago, stagflation — a combination of stagnant growth and price inflation — caused young economists to question the Keynesian orthodoxy they had been taught as Ph.D. students.
That touched off what became the “rational expectations revolution,” an approach to macroeconomics that incorporated the same assumptions of extreme rationality embodied in Fama’s micro work in finance. It became, in academic circles if not in policy ones, the new dominant model.
Now, the financial and economic debacles of the past decade are leading a new cohort of young economists to question their own indoctrination. Many are looking at what they learned in grad school and finding it wanting.
This movement to rebuild economic theory on human behavior — as explained by modern experimental psychology rather than 19th century assumptions — is gaining strength. There are new organizations and new research programs.
Lars Peter Hansen, the third and least well-known of the 2013 laureates, is part of this movement. A professor at the University of Chicago, Hansen also participates in an organization called the Institute for New Economic Thinking.
The Institute, which largely is a research-funding and collaboration-fostering organization, somewhat like the National Bureau of Economic Research, asserts that “the havoc wrought by our recent global financial crisis has vividly demonstrated the deficiencies in our outdated current economic theories, and shown the need for new economic thinking.”
That’s not something Fama or many others of his generation would agree with. Shiller might. But in any case, Hansen’s affiliation with this group says something about his view of the state of economic theory. Change is healthy, and old ideas in economics are being challenged.