The Economics Nobel Highlights a Big Unanswered Question: We still don’t know nearly enough about why the prices of stocks, bonds and other assets move the way they do

The Economics Nobel Highlights a Big Unanswered Question

The awarding of a Nobel Prize to three economists with divergent views on the working of markets highlights a troubling truth about the state of the discipline: We still don’t know nearly enough about why the prices of stocks, bonds and other assets move the way they do. If the economics profession wants to help the world avert – – or at least better survive — financial crises, it will have to be more open to new ways of looking at this question.The recipients of this year’s Sveriges Riksbank Prize in Economic Sciences — Eugene F. Fama and Lars Peter Hansen of the University of Chicago and Robert J. Shiller of Yale University – – have all made important contributions to the understanding of financial markets. Fama demonstrated that markets are very good at processing new information quickly. Shiller showed that despite this, prices can get out of whack and stay there for long periods of time. Hansen provided tools to help figure out whether markets’ often odd behavior can happen in a world where investors are rational, or must be explained by human bias or some other malfunction.

Unfortunately, decades after the three economists had their groundbreaking insights, the crucial question remains unanswered: Can policy makers know with any certainty when markets are dangerously out of line, and is there anything they can do about it?

Central bankers still debate whether it’s possible to recognize asset bubbles when they occur, and whether they can or should be deflated. Regulators and bankers are still at odds over new financial products such as credit derivatives: Do they simply improve the market’s ability to process and reflect information, or do they also present new dangers of their own?

This is a failure that left the world unprepared for the most recent financial crisis, and the economics profession has been far too complacent about it. Economists can’t be expected to predict the future. But they should be able to identify threatening trends, and to better understand the conditions that can turn a change in prices into a financial tsunami.

On the margins, economists are doing promising work, together with researchers from other disciplines such as physics. Some, taking their cue from the computer modeling that helps forecast events such as hurricanes, are trying to build more realistic models of markets and the economy that take into account the interactions of countless individuals. Others are looking at how investors with differing views, using leverage, can turn otherwise benign financial instruments into tools of disaster.

What’s amazing is that the largest and most prestigious universities aren’t placing more emphasis on such paradigm-shifting work. For young researchers trying to get published and land good jobs in academia, challenging the conventional wisdom — and questioning the workings of a financial industry that provides lucrative backing to business schools — can be perilous. The commanding heights are often occupied by tenured professors heavily invested in the status quo.

This year’s Nobel shows the economics discipline in all its frustrating, admirable splendor. With apologies to Harry Truman’s jaundiced view of economists, it’s only a matter of time before the joke starts making the rounds: Did you hear about the two economists who couldn’t agree on how markets work? Yeah, they won a Nobel for it.

Yet if better understanding of that question is possible, it will come only through trial and error, the positing and refuting of theories. This is exactly the kind of creative thinking and intellectual risk-taking that Fama, Hansen and Shiller engaged in. It’s also what the economics profession needs more of as it continues to try to understand financial markets and how they can go awry.

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What Fama and Shiller Didn’t Teach Us About Finance

This morning, the Nobel Foundation awarded the memorial prize in economics to Eugene Fama, Lars Peter Hansen and Robert Shiller, and it struck some people as a bizarre act of self-negation.

Here’s why: Fama is known for developing the theory of “efficient” markets after failing to develop trading signals for a professor while in college. His experience led him to the important insight that it is almost impossible for ordinary people to beat the markets, which later led to the introduction of low-fee index funds. Shiller, by contrast, focused on the ways that fear and greed can lead to the mispricing of financial assets. He correctly warned that U.S. equities were expensive in the late 1990s, and that U.S. house prices were overvalued in the early to mid-2000s. (Hansen’s contributions, while important, don’t have the same practical applications for investors.)

Yet while Fama and Shiller may seem to offer contradictory insights, both men have more in common with each other than either does with the newer brand of finance researchers. That’s because both economists agree that asset prices reflect investor expectations. Their disagreements boil down to differing views about the sources of those expectations.

For Fama, investors in the aggregate are “rational” — they pay attention to the news and understand how new information affects the attractiveness of various assets. There may be plenty of dumb day-traders, but their activities ought to cancel each other out. Shiller, on the other hand, believes that expectations are shaped by experience. Nothing changes a man’s opinion about the upside potential of the S&P 500 like watching his idiot neighbor get rich by buying Netscape shares after the initial public offering.

There is a newer generation of researchers, however, that recognizes the importance of expectations but also looks at other real-world factors determining asset prices, such as the structure of financial markets. Andrei Shleifer and Robert Vishny, wrote a crucial paper in 1997 explaining that smart traders can’t bet against bubbles if they have to endure margin calls, for example. John Geanakoplos has focused on the ways that leveraged betting can increase the likelihood of extreme events that “shouldn’t” occur if price changes are randomly distributed. Tobias Adrian, Emanuel Moench and Hyun Song Shin have shown that asset prices seem to be determined by the willingness of investment banks and other financial firms to borrow, which in turn is affected by monetary policy.

What Fama and Shiller have in common, then, is having made contributions to our understanding of asset pricing for which regular investors should be thankful. But in our post-Great Recession world, policy makers, regulators and risk managers will probably be more indebted to the newer research with a firmer foot in the real world.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)