Economists clash on market theory, still share Nobel

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WASHINGTON -- Economist Robert Shiller in 2005 described the rapid rise of housing prices as a bubble and warned that prices could fall by 40 percent. Five years later, with home prices on the way to fulfilling Mr. Shiller's prediction, economist Eugene Fama said he still did not believe that there had been a bubble.

"I don't even know what a bubble means," said Mr. Fama, author of the theory that asset prices perfectly reflect all available data. "These words have become popular. I don't think they have any meaning."

The two men, leading proponents of opposing views about the financial markets' rationality -- a dispute with important implications for investment strategy, financial regulation and economic policy -- were joined in unlikely union Monday as winners of the Nobel Memorial Prize in Economic Science.

Mr. Fama's seminal theory of rational, efficient markets inspired the rise of index funds and contributed to a decline in financial regulation. Mr. Shiller, perhaps his most influential critic, assembled evidence of irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as well as the housing crash that began in 2006.

The two Americans will share the award with a third U.S. economist, Lars Peter Hansen, who developed a statistical analysis method to evaluate price movement theories widely used by other social scientists.

The three economists, who worked independently, were described as collectively illuminating financial markets' workings by showing that stock and bond prices move unpredictably in the short term but with greater predictability over longer periods. The prize panel said these findings showed that markets were moved by a mix of rational calculus and irrational behavior.

Mr. Fama and Mr. Hansen are professors at the University of Chicago, known as the principal home of free-market economics; Mr. Shiller is a Yale University professor. Their work "laid the foundation for the current understanding of asset prices," said a statement from the Royal Swedish Academy of Sciences, which awards the annual prize.

In jointly honoring the work of Mr. Fama and Mr. Shiller, the committee highlighted how far the economics profession remains from agreeing on the answer to a basic and consequential question: How do markets work? "It encapsulates the state of modern economics," said University of Michigan economist Justin Wolfers. "We have big important questions that remain largely open, and we have giants bringing evidence to bear. And the answer turns out to be more complicated than markets are efficient -- or markets are inefficient."

The dispute is not merely academic. Deregulation of financial markets starting in the 1980s was justified by the view that markets are rational and efficient. Complacence about rising home prices in the 2000s similarly reflected the view that prices are inherently rational. In the crisis' aftermath, conversely, the work of Mr. Shiller and other proponents of behavioral economics -- the integration of psychology into economic models -- has been influential in shaping an intensification of financial regulation. Federal Reserve officials now are debating whether bubbles can be identified, and when they should be popped.

Mr. Fama, 74, was honored for showing in the 1960s that asset prices are "extremely hard to predict over short horizons." The theory basically asserted, in the words of economist Burton Malkiel, that "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts." It has been repeatedly validated, sometimes in experiments involving actual monkeys.

And while many Wall Street prognosticators still thrive in part by claiming that they can offer investments that will consistently beat the market averages, Mr. Fama's well-established theory has influenced the way millions of people now invest, contributing to the popularity of index funds that hold broad, diversified baskets of equities.

Mr. Shiller, 67, introduced in the early 1980s an important limitation on the idea that markets operate efficiently. He showed that stock prices' volatility was greater than that of corporate dividends. Moreover, he found some of those irrational deviations fell in predictable patterns.

Mr. Shiller is among a group of prominent economists trying to integrate behavioral theories from psychology and other social sciences into rigorous models of economic activity.

Bubbles are one of the most tangible manifestations of the disagreement between Mr. Shiller and Mr. Fama. The housing crash that began in 2006 is widely seen as evidence that prices had climbed to irrational heights, and Mr. Shiller's accuracy in diagnosing that suggests future bubbles could be identified, too.

Mr. Hansen, 60, was honored for developing the "generalized method of moments," a technique to evaluate relationships among explanatory factors that lets social scientists work around the absence of some kinds of data.

Uncertainty plays a large role in economics, but Dennis Epple, head of economics at Carnegie Mellon University's Tepper School of Business, has long felt confident of one outcome: that Mr. Hansen, who started his career at CMU, would one day win the Nobel prize for economics.

"We are delighted that it has now happened," said Mr. Epple, who is CMU's Thomas Lord University professor of economics. "The importance of his contributions is such that we knew that he would get the prize."

Mr. Hansen, who received his doctorate in economics from the University of Minnesota, arrived at Carnegie Mellon in 1978 for a job in its business school. Mr. Epple was part of the committee that hired him, and he remembers "we were just tremendously impressed by him."

Mr. Hansen started at CMU as an assistant professor and was promoted two years later to associate professor. Typically, that takes five or six years, Mr. Epple said. Mr. Hansen left Pittsburgh in 1981 for Chicago.

In 1982, he and CMU faculty member Kenneth J. Singleton published a paper that developed a new method to test the practical relevance of economic theories. Mr. Epple said Mr. Hansen has gone on to show how application of his methods can be used in studying how people trade off risk and return.

Mr. Epple said his former colleague's methods have led to an understanding of asset pricing and have had wide application, including in energy markets and tax policy.

Mr. Hansen's award makes him the ninth Tepper graduate or faculty member to win the economics prize, and the 19th Nobel winner affiliated with Carnegie Mellon.


Post-Gazette staff writer Kaitlynn Riely contributed. First Published October 14, 2013 8:00 PM


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