The Nobel committee is muddled on the nature of economics; The term ‘rationality’ lacks relevance in a world characterised by imperfect information

October 15, 2013 1:40 pm

The Nobel committee is muddled on the nature of economics

By John Kay

The term ‘rationality’ lacks relevance in a world characterised by imperfect information

The Royal Swedish Academy of Sciences continues to astonish the public when awarding the Nobel Memorial Prize in Economics. In 2011 it celebrated the success of recent research in promoting macroeconomic stability. This year it pays tribute to the capacity of economists to predict the long-run movement of asset prices.People with knowledge of financial economics may be further surprised that this yearEugene Fama and Robert Shiller are both recipients . Prof Fama made his name by developing the efficient market hypothesis, long the cornerstone of finance theory. Prof Shiller is the most prominent critic of that hypothesis. It is like awarding the physics prize jointly to Ptolemy for his theory that the Earth is the centre of the universe, and to Copernicus for showing it is not.

Actually, it is not as bad as that analogy suggests. Although the efficient market hypothesis is not true, the basic idea – that there is a tendency for publicly available information to be reflected in market prices – is an essential tool for anyone involved in securities markets. And while the claim that economists are good at predicting long-run asset prices is a stretch, Prof Shiller’s research supports strong evidence of long-run mean reversion, as prices return to the fundamental values established by the earning capacity of the underlying assets.

Still, both these insights were available to market practitioners from common sense and casual observation long before the complex mathematics and extended data sets of academic financial economics. The prize committee gives the misleading impression that there is an agreed, established and advancing body of knowledge in financial economics: but the subject, for half a century a showpiece in economic departments and business schools because of its mix of intellectual rigour and practical relevance, is today struggling to maintain credibility in the face of the financial instability of the past two decades.

The problem is not the efficient market hypothesis itself, which should be understood as a tendency, not a law. The problem is with the superstructure built around it – a world of rational agents holding rational expectations achieving a state of “equilibrium” – a term economists have borrowed from physics – through trade with other rational agents holding similar rational expectations. In a masterpiece of persuasive language, the word “rational” is used to describe agents and expectations with a meaning very different from its ordinary usage.

This theory is easier to defend for its logical consistency than for the supporting empirical evidence. The capital asset pricing model to which it gives rise offers a striking, and counterintuitive, proposition: that the idiosyncratic risk associated with individual speculative projects, such as pharmaceutical research or weapons programmes, needs no reward above that accruing to riskless investments; but the risk associated with macroeconomic uncertainty experienced by all companies will require a substantial premium. The most striking empirical demonstration that this prediction is not true is found in the work Prof Fama undertook himself; while the most important contribution of his co-laureate, Prof Shiller, was to show the volatility of stock market prices far exceeds that justified by new information relevant to fundamental values.

But we do not have to believe, like Prof Fama, that we all correspond to his concept of rationality or, like Prof Shiller, that we are slaves to our psychological weaknesses. There is a middle course, which understands that the economists’ use of the term “rationality” lacks relevance in a world characterised by imperfect information; that rational expectations are impossible in the face of radical uncertainty; and that it is implausible that constantly changing securities prices represent an equilibrium.

There was no scope for compromise on the nature of the physical world: Copernicus was right and Ptolemy was wrong. There are not, and will not be, equivalent certainties in economics, and if such certainty is the hallmark of science – I do not think it is – then economics is not a science. The resulting insecurity seems to lead the Nobel committee to claim more for the subject of economics than it has achieved.

johnkay@johnkay.com

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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