he news that the Nobel Prize in Economics was awarded to Robert Schiller, Eugene Fama, and Lars Peter Hansen came as a surprise to a lot of interested parties. Two of the three economists — Fama and Shiller — are known for their work on seemingly contradictory theories about how the market prices assets.
Here's The New York Times' Binyamin Appelbaum on the announcement:
Confusing morning. Either Fama is right or Shiller is right, no?— Binyamin Appelbaum (@BCAppelbaum) October 14, 2013
Awarding a Nobel to Fama and Shiller jointly is basically the reason, on an intellectual level, that economic policymaking is broken.— Binyamin Appelbaum (@BCAppelbaum) October 14, 2013
Fama and Shiller's theories do seem to directly oppose each other. Fama, 74, is known for his work in developing the "efficient markets hypothesis" — the idea that asset prices change very quickly based on new information, like quarterly earnings' announcements, or new management. His work suggests that the market already reflects all known, relevant information, and individual investors trying to outsmart its wisdom and predict its movements are doing so in vain.
Shiller, 67, meanwhile, is known for his work in studying the inefficiencies of markets. His research shows how human behavior and psychology — especially appetite for risk — can lead to large and prolonged periods of mispricing in the marketplace (i.e. the mid-2000's housing bubble). "His work in behavioral finances examines individual investors' tendency to bandwagon (buy high and sell low) and financial markets' tendency to gyrate wildly around fairly predictable long-term fundamental trends," says Matthew Yglesias at Slate.
So, why is the same award going to the grandfathers of two theories that seem to overtly contradict each other? They both contributed to our understanding about the same thing, says Yglesias. "The lines of research from Fama, Hansen, and Shiller are all rather different but they're all groundbreaking empirical investigations of the same basic issue — what happens with financial market prices and why," he writes.
And just because Shiller and Fama seem to contradict each other, doesn't mean one is right, the other wrong. "In effect, with the joint award, the Nobel committee was attempting to fuse those competing schools of thought in order to recognize what economics knows now that it didn't a generation or two ago about where asset prices come from, a unified theory of sorts," says Neil Irwin, in The Washington Post. Fusing the theories, he argues, is possible because of how they interact with separate, but complimentary timeframes:
The fusion of Fama's, Hansen's and Shiller's research, then, boils down to this: We know that stock prices behave randomly on short-term horizons, and that efforts to time the market in the short run are probably counterproductive. But we also know that markets can become broadly mispriced for long periods due to the mysteries of human psychology. [The Washington Post]
Still, Shiller's theories are more popular now, in the aftermath of a historic bubble. "The idea of efficient markets has taken a pounding over the past few years, so the timing of Prof Fama’s honour seems awkward," says Tim Harford in the Financial Times. But Fama's work could have prevented the financial crisis as well, he says:
In the light of the financial crisis, the contribution of Prof Shiller to economic thought is obvious. Prof Fama’s is more subtle: If more investors had taken efficient market theory seriously, they would have been highly suspicious of subprime assets that were somehow rated as very safe yet yielded high returns. Any follower of Eugene Fama would have smelled a rat. [Financial Times]
For their part, the Nobel committee clearly sees the value in both contributions. "The Laureates have laid the foundation for the current understanding of asset prices," it wrote in its announcement. "It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions."
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