Economists Do It With Models

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Your Nobel Winners, Econgirl Style…

October 14th, 2013 · 5 Comments

Confession: I had a coffee meeting this morning, so I only momentarily checked the news to see who’d won the Nobel Prize. I should have known better than to click on the story from the Chicago Tribune rather than the Nobel Prize web site, since the article was basically “ZOMG Eugene Fama won the Nobel…oh, and two other dudes, one of whom is from Chicago.” Hopefully that explains why I tweeted this:

This is one of the many reasons that I should not be allowed to tweet before I have my morning coffee. In reality, a better headline would have been “The Efficient Markets Hypothesis Guy, The Guy Who Made Your Grad-School Life Hell, and The More or Less Behavioral Guy Who Disagrees With Most of What The Efficient Markets Hypothesis Guy Says Win the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.” (See what I did there, nitpickers?) You could read some very nice summaries here, here, or here, or you could allow me to explain…

The first winner is Eugene Fama, with the Efficient-Markets Hypothesis:

The efficient markets hypothesis has historically been one of the main cornerstones of academic finance research. Proposed by the University of Chicago’s Eugene Fama in the 1960’s, the general concept of the efficient markets hypothesis is that financial markets are “informationally efficient”- in other words, that asset prices in financial markets reflect all relevant information about an asset. One implication of this hypothesis is that, since there is no persistent mispricing of assets, it is virtually impossible to consistently predict asset prices in order to “beat the market”- i.e. generate returns that are higher than the overall market on average without incurring more risk than the market.

Or, in more helpful prescriptive terms, “you can’t systematically beat the market, stupid, so just go buy an index fund.” As a behavioral economist, I am well aware that there are a lot of people whose life’s work it is to catalog and try to explain the ways in which markets deviate from efficiency (including one new Nobel Laureate named Robert Shiller- see below), and I find a lot of the evidence compelling. That said, I don’t find the evidence to be of the sort that the average individual investor could capitalize on effectively, so, personally, I find the “don’t even try” implication of Fama’s work to be quite important and good advice even if I don’t always buy what he’s selling.

As for Lars Hansen, well, he’s the reason that I had to do a bunch of Generalized Method of Moments estimations in my Industrial Organization class, so screw that guy. Just kidding- he’s pretty legit, though pretty far from anything that I have expertise in, and I worry a little that he’s going to be the economic equivalent of the World-Series-winning Florida Marlins team that no one remembers as much as Aaron Boone’s walk-off home run in the Yankees/Red Sox ALCS. (Look, if Bloomberg gets to make a Red Sox/Yankees reference, so do I.)

Lastly, I have to imagine that the Nobel call to Robert Shiller went something like this:

Adam Smith (yes, that is a real possibility): Dr. Shiller, I have some good news and some bad news for you. Which would you like first?
Robert Shiller: The good news, I suppose, though the fact that you’re calling me at 3a.m. local time on Nobel Prize day gives me a bit of a hint.
Smith: The good news is that you are one of the economists chosen to win the Nobel Prize in Economics this year. (Sidenote: I am reluctant to believe that even the Nobel people refer to the prize by its correct name.)
Shiller: Um, wow, thank you. And…the bad news?
Smith: You will be sharing the prize with Eugene Fama and Lars Hansen.
Shiller: Um…am I being Punk’d? Like, is Ashton Kutcher going to appear in my living room now or something? You do realize that my best-known work is entitled Irrational Exuberance, right?
Smith: We do, sir.
Shiller: And you’re…you’re sure that you want me on the same stage as this guy? Allow me to quote a few passages:

Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst.

I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.

here were some people out there saying this was an unsustainable bubble…

Right. For example, (Robert) Shiller was saying that since 1996.

Yes, but he also said in 2004 and 2005 that this was a housing bubble.

O.K., right. Here’s a question to turn it around. Can you have a bubble in all asset markets at the same time? Does that make any sense at all? Maybe it does in somebody’s view of the world, but I have a real problem with that. Maybe you can convince me there can be bubbles in individual securities. It’s a tougher story to tell me there’s a bubble in a whole sector of the market, if there isn’t something artificial going on. When you start telling me there’s a bubble in all markets, I don’t even know what that means. Now we are talking about saving equals investment. You are basically telling me people are saving too much, and I don’t know what to make of that.

In the past, I think you have been quoted as saying that you don’t even believe in the possibility of bubbles.

I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble. People have become entirely sloppy. People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it.

Smith: Sir, we thought about this long and ha…look, do you want the prize or not?
Shiller: *taps 8 million Swedish kroner into his calculator and divides by 3* Yeah I guess so…I mean, it would be “irrational” of me not to take it. *rolls eyes*

Overall, these are interesting/good choices I suppose, but I can’t help but feel that, based on his recent work at least, Steve Levitt was robbed. Luckily, there’s always the Ig Nobel Prize to hope for, but I’m guessing it doesn’t come with as much cash.

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5 responses so far ↓

  • 1 Jeff // Oct 14, 2013 at 6:00 pm

    Interesting post.

    “You are basically telling me people are saving too much, and I don’t know what to make of that.”

    I would suggest that how you react to the idea of people saving “too much” is one of the key predictors of which school of economics you subscribe to.

  • 2 BZ // Oct 14, 2013 at 6:13 pm

    Fantastic post Miss Beggs — gave me an interesting first-contrast between the winners (I’m sure I’ll read more later). When you describe their differences, my first thought is not “has the Nobel committee gone nuts”, but, “Under what theory does the Nobel committee do this and take themselves seriously.” The best I can come up with is that they approach the prize the way “Time” does their person of the year, giving it to Hitler at one time and Mother Theresa at another — IOW, trying to award significance over Metaphysical Truth?

    On another note, I was, like Jeff, also confused by the notion of “saving too much”, as well as by the notion that investment == savings, like, since when has that been true? 1912? 1512?

  • 3 econgirl // Oct 14, 2013 at 8:37 pm

    Technically, savings only equals investment in a closed economy at equilibrium and when people aren’t saving by stuffing cash under their mattresses. It’s also worth noting that savings is also the sum of public and private savings, where public savings is negative if the government is running a deficit. In an open economy, savings equals investment plus net capital outflow, which represents the difference between how much domestic saving is going to foreign investment and how much foreign saving is going to domestic investment.

    That said, I’m not sure how the evidence shakes out on whether real interest rates adjust perfectly to bring this equilibrium into balance at all points in time.

    You would probably appreciate that one of the articles I read made a joke about how Nobel committee has awarded prizes to scientists who contradicted one another, but it hasn’t really happened for two people in the same year.

  • 4 Nathanael // Oct 15, 2013 at 10:59 am

    “That said, I don’t find the evidence to be of the sort that the average individual investor could capitalize on effectively,”

    FWIW, the way an individual investor beats the market is by *paying more attention* and *doing more research* and *understanding it better* than the average guy in the market. The same information can be *available* to everyone, but not everyone *processes* it.

    Most people simply don’t want to spend the time on it, which is why they should be in index funds. If you’re obsessively researching this stuff anyway, though, you can do very well — ask Keynes.

  • 5 econgirl // Oct 15, 2013 at 12:29 pm

    Oh, I don’t entirely disagree with that, though it doesn’t explain why even professional mutual fund managers also find it difficult to consistently beat the market. I am, however, well aware of the Dunning-Kruger effect:

    Therefore, the EMH telling people that it’s impossible to beat the market could actually get them into index funds, whereas telling people that it’s hard to beat the market likely just sets up a challenge for unsophisticated investors. 🙂

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