Three American professors have been awarded 2013 Nobel Prize in Economics. They "laid the foundation for the current understanding of asset prices," as the Royal Swedish Academy of Sciences commented. "It relies in part on fluctuations in risk and risk attitudes, and in part on behavioural biases and market frictions." Their work spans almost 50 years of research, beginning with the finding by the University of Chicago's Fama that it's difficult to predict price movements in the short run. That conclusion forms the basis for the theory that financial markets are efficient and led to the development of stock-index funds. Robert Shiller, who shared the 8.0 million Swedish krona (781 thousand pounds) prize with fellow laureates Eugene Fama and Lars Peter Hansen, said the US Federal Reserve's economic stimulus and growing market speculation were creating a "bubbly" property boom.
The Royal Swedish Academy of Sciences lauded the economists' research on the prices of stocks, bonds and other assets, saying "mispricing of assets may contribute to financial crises and, as the recent global recession illustrates, such crises can damage the overall economy." This was the case in the collapse of the US housing market, which helped trigger the 2008-2009 global financial crisis. Markets are at risk of committing the same error now, Shiller told Reuters after learning he had won the Nobel prize. "This financial crisis that we've been going through in the last five years has been one that seems to reveal the failure to understand price movements," Shiller said. Shiller and other economists warn that prices in some markets have risen too far, too fast due to the Fed's ultra-easy monetary policy. The benchmark US Standard & Poor's 500 index hit a record in September, though it is generally not considered overvalued based on expectations for corporate earnings results or economic growth. In June this year, he pointed to a potential new housing bubble in some of America's largest cities. "It is up 12 per cent in the last year. This is a very rapid price increase right now, and I believe that it is accelerated somewhat by the Fed's policy," he said. China, Brazil, India, Australia, Norway and Belgium, among other countries, were witnessing similar price rises. "There are so many countries that are looking bubbly," he said. This view of how assets are priced is at odds with Shiller's belief that investors can fall prey to "Irrational Exuberance," the title of his 2000 book, shortly before the bursting of a global bubble in information technology stocks.
Central bankers traditionally try to avoid targeting asset bubbles with a blunt instrument like interest rates. But the severe harm done when a bubble bursts means that, in the United States at least, they are thinking more broadly about the unintended consequences of their monetary policy decisions. "When asset prices are getting way out of line it should be cause for alarm. The monetary authorities should lean against extreme asset price movements," Shiller said. The bubbling housing market is not mainly the result of central bank policy, but reflects a shift toward "a more speculative attitude," Shiller said. "We cannot expect monetary policy to cure all of these problems." Hansen struck a more cautious note. "We often underestimate how much uncertainty there is in terms of our understanding of the economy," he said. "If you pretend that we know more than we do, you are in danger of constructing policies that can be counter-productive." Hansen, who voiced caution about the ability of economists to spot asset bubbles in advance, said there were different ways to interpret evidence. "In terms of overall understanding I guess there is a sense in which one could view them as complimentary," he said of the research of his co-winners. "But right now, they would both have very different guesses about what is the right set of models going forward," he said in an interview.
The name of Fama has been heard as a Nobel winner for many years. He has been called the father of modern finance and is well-known for research showing certain groups of stocks tend to outperform over time, and for thinking about markets as efficient. Fama and Hansen are professors at the University of Chicago, while Shiller is a professor at Yale University. Collectively, with research spanning decades, their work helped the emergence of index funds in stock markets. Peter Englund, professor of banking at the Stockholm School of economics and member of the prize committee, said," their research had deeply influenced modern finance. The most obvious application, that follows on from Fama's research, is the insight that you can't beat the market. It is impossible to prove that equity analysis is worth the money". Yale University's Shiller, in particular, took issue with the argument that investors are always logical, using the phrase "irrational exuberance" to explain run-ups in asset prices. The winners represent a "very interesting collection because Fama is the founder of the efficient-market theory and Shiller at least is one of the critics of it," said Robert Solow, winner of the Nobel economics prize in 1987 and professor emeritus at the Massachusetts Institute of Technology in Cambridge. The award comes five years after a financial crisis that drove the US and world economies into their deepest recession since the Great Depression.
In the mid-1960s, Fama propounded theories arguing that stock-price movements are unpredictable and follow a "random walk," making it impossible for any investor, even a professional, to gain an advantage. He also showed in later work that so-called value and small-cap stocks have higher returns than growth stocks, and he rejected the notion that markets often produced bubbles. "Fama's research at the end of the 1960s and the beginning of the 1970s showed how incredibly difficult it is to beat the market, and how incredibly difficult it is to predict how share prices will develop in a day's or a week's time," said Peter Englund, professor in banking at the Stockholm School of Economics and secretary of the committee that awards the Nobel Prize in Economic Sciences. "That shows that there is no point for the common person to get involved in share analysis. It's much better to invest in a broadly composed portfolio of shares." Fama said he learned of the award while preparing for a class on portfolio theory and asset pricing. A native of Boston, Fama earned a bachelor of arts degree at Tufts University in Medford, Massachusetts, in 1960, and went on to the University of Chicago, where he received a master of business administration degree in 1963 and a doctorate in 1964.
Since 1981, Shiller has been at the vanguard of economists chipping away at the theory of efficient markets. His research showed that investors can be irrational and that assets from stocks to housing can develop into bubbles. Shiller found that stock prices were bad 'weathermen,'" said Nobel laureate George Akerlof, an economics professor at the University of California at Berkeley and husband of Janet Yellen, President Barack Obama's nominee to be Federal Reserve chairman. "Historically, they have been much more variable than the current value of the dividend streams." From this evidence, he concluded that rational models of the stock market, in which stock prices reflect rational expectations of future payouts, are in error. This clever combination of logic, statistics, and data implies that stock markets are, instead, prone to irrational exuberance. Born in Detroit in 1946, Shiller earned his PhD in economics from the Massachusetts Institute of Technology in 1972. He told reporters that he learned of the award while "getting out of the shower this morning. I wasn't properly dressed, but I didn't want to miss the phone call." Shiller said the 2008 financial crisis "reflected mistakes and imperfections in our financial system that we are already working on correcting. I think there's much more to be done. I think it will take decades. But we've been through financial crises many times in history and we generally learn from them. Shiller's research showed episodes when assets were overvalued," said Englund. When information technology shares rose in the 1990s, Shiller argued "that this is not sustainable in the long-term, which he was right about," Englund said.
Hansen is one of the co-founders of the Becker Friedman Institute at the University of Chicago, which builds on the legacy of Milton Friedman. His work explores the implications of dynamic economic models in which decision makers face uncertain environments. He is perhaps best known as the developer of a statistical technique called the generalized method of moments, which broadens the assumptions that researchers can count on, allowing them to focus on other suppositions and linkages in their work. "The choice of having Hansen complement the two extremes of efficient markets and inefficient markets is the perfect balance between the two," said Andrew Lo, a professor of finance at MIT's Sloan School of Management. Hansen's development of econometric techniques for analyzing data and asset prices allows economists to test the various theories on what drives markets, he said. Hansen's "remarkably general empirical methods free researchers from the need to make a range of empirically implausible statistical assumptions about the data that they are studying," Kocherlakota added. "By doing so, Lars's methods allow economists to assess the core economic implications of their models and theories relative to the data of interest." Born in Champaign, Illinois, Hansen received his PhD in economics at the University of Minnesota in 1978 and his bachelor's degree in mathematics and political science from Utah State University. Hansen told reporters that he learned of the award after walking his dog and while getting ready to go out and exercise with his personal trainer.
Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said in an e-mail "Lars is a true giant in both economics and finance." Hansen was Kocherlakota's PhD adviser at the University of Chicago. Lo said the Nobel committee's decision in giving the award to Fama and Shiller "definitely shows a certain flair for irony." The message, he added is that "financial markets can be efficient most of the time but every once in a while they break down and then we need to develop better analytics to be able to understand them."
Last year's prize was awarded to US economists Alvin E Roth and Lloyd S Shapley for their exploration of how to make markets work more efficiently by better matching supply with demand. In 2009, Elinor Ostrom became the first woman to win when she received the prize together with Oliver Williamson for investigating the limits of markets and how organizations work.
The award of the prize acknowledged the wide impacts of their work outside their immediate field of study. Mr Hansen's statistical models have been used in all sorts of fields. The work of the other new laureates has also been cited as changing practice across finance industry, well beyond the confines of academic economics. For instance, Mr Fama's conclusions about market efficiency have encouraged the emergence of so-called index funds in financial markets. Mr Shiller has applied his work by creating the monthly Case-Shiller index (with economist Karl Case), which many asset managers now find to be an indispensable tool to measure house prices in cities across America. The committee, to its credit, managed to recognise work that has been innovative within the ivory tower and relevant outside it.
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The writer is Program Manager: BRAC Education Program and Vice-President: Bangladesh English Language Teachers Association (BELTA). Email: [email protected]
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