If you are invested in an index fund, you can thank Eugene Fama of the University of Chicago, one of the three Americans to win the Nobel Prize in economics. Fama’s research indicated that trying to time the market or pick stocks was a fool’s errand. Instead, asset prices already reflect all the information known. This important piece of “efficient markets theory” gave rise to index funds.
But even Nobel laureates can’t get it right all the time (President Obama, Nobel Peace Prize winner, recently wanted to bomb Syria). Brad DeLong of UC, Berkeley posted an astonishing interview of Fama by the New Yorker’s John Cassidy, in which the new Nobel laureate pretty much denies that bubbles happen and claims that the housing crash could only be seen in hindsight.
And even if the crash caused the recession, which Fama denies, it was because of people getting Fannie and Freddie loans, not because of a fundamental failure in the market driven by private-sector greed, leverage and risk-taking. Even your humble economics columnist called the housing crash, so c’mon. The “free market” hothouse of Chicago grows exotic flowers.
But wait. Another winner is the estimable Robert Shiller of Yale, who did pioneering research into how markets can be very inefficient. Chris Dillow does a good job of sorting out their positions and how they can be reconciled. (Lars Peter Hansen, also of Chicago, was the third winner announced today).
While Fama’s theoretical work was useful in finance, Shiller is more the realist about human action in the market — how it indeed gets out of control or any elegant notion of equilibrium. A behavioral economist, Shiller warned of both the 2001 tech-bubble collapse and also the real-estate disaster.
The question facing Fama is that, at age 74, he did much of his groundbreaking work in a very different world. Wall Street was the province of prudent white-shoe firms. Glass-Steagall prevented taxpayer-insured, commercial banks from getting into the risky business of investment banking. The market not only was better policed, but stocks were held longer and considered true ownership of productive firms. The payoff came slowly, often from dividends.
The merger manias, tearing apart enterprises that it took decades to build for a quick profit, and “shareholder value” movement were yet to come. So were derivatives, shadow banking and deregulation, even if Fama’s “efficient market” theory was used to bolster the arguments in favor of all these destructive tools. Then there is persistent insider trading and high-speed, computerized flash trading, both of which further tilt the market in favor of the Wall Street Boyz and against average investors.
So congratulations to the new laureates. Unfortunately, the dissonance between Fama and Shiller shows we haven’t had a healthy market for some time. A fixed market is “efficient” for only the few.
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Today’s Econ Haiku:
The minimum wage
Used to be a way station
Now a way of life